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ALWAYS CONSULT YOUR INVESTMENT PROFESSIONAL BEFORE MAKING ANY INVESTMENT DECISION

July 19, 2015 | Special

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

 Two weeks ago the high-priced economists at Scotiabank sent this message to clients:

“The country is not in recession in any meaningful or broadly defined way at this point, and we believe that the BoC should not and will not cut next week. A dovish bias has merit, but it is likely premature to give up on the rebound story and court the substantial risks associated with further rate cuts. Whether a cut happens or not, we’re likely to see higher short-term market rates emerge…”

Since then, the geniuses who run our national interest rate policy dropped the cost of money. You know the rest. The dollar tanked. Realtors went woody. And many observers worried we’re just suckering in consumers for a big debt-punch to come in a year or so, as rates in both the US and Canada swell.

But there was one other casualty to mention. Preferred shares sank in value along with bond yields and the central bank rate. This raised a chorus of moaning and gnashing among those confused people who own preferreds and believe everything in their portfolio should always go up. So let’s discuss this for a moment.

Preferred shares are not really shares in the sense of common stock, or equity. Instead they’re a hybrid between stock and bonds. Like equities (and unlike bonds) they pay dividends. But like bonds (and unlike equities) the dividends are fixed. Preferreds are also considered safer and more stable than common stock because they exhibit less volatility in price, and the dividends must be paid first. Hence the name ‘preferred.’ Special. Just like your mom called you.

So investors who own preferreds get a steady stream of predictable dividend income which flows regardless of the current price of the asset. They enjoy less volatility than with the common stock of the same company (issuer). They have a safer income stream because even in a crisis (like 2008-9) preferred dividends are usually untouched (that was the case with every major bank). Income flows to you from preferreds every 90 days. And you can claim the dividend tax credit when you file your return, boosting the effective yield – which currently sits in the 5% range for a basket of Canadian prefs.

All good. But what about this decline recently in the capital value of preferreds? Should some of the pantywaists and tim’rous beasties who read this pathetic blog really be stressed out over the dip? Why has the preferred share index on the TSX lost 14% this year? Should you throw yourself under a bus?

Hardly. Just the opposite. This has the scent of a giant buying opportunity.

Most preferreds today are called ‘rate-reset,’ which means investors gain protection from rising interest rates since the dividend is reset periodically, based on the Government of Canada five-year bond yield, plus a premium. And if rates soar, the issuers have the ability to recall the shares, giving investors a capital gain. This is reasonable in a world in which it’s a no-brainer that the cost of money will rise over time.

But, as you know, rates have not risen as everyone expected. They’ve fallen. Temporarily. So preferreds have dropped in price along with bond yields, while continuing to churn out their dividends. Not quite understanding what they bought, or why, lots of retail investors have bailed out of preferreds, since they confuse them with common stock and are dumping an asset with a double-digit ‘loss.’

Big mistake.

The preferred share market is now oversold, and looks cheap. Sellers should be buying, then holding between 15% and 18% of their balanced portfolio in these puppies. Here’s why:

First, as Scotiabank (and this blog) believes, rates will inevitably be rising. The US Fed will move later this year, and once it starts the momentum will continue for at least a couple of years. Since the Bank of Canada has followed the Fed lead 90% of the time over the last quarter century (and since our dollar’s getting killed) our rates will follow. Preferreds will feast on this.

Second, preferreds currently offer a huge spread over corporate bonds, are under-valued and destined to be gobbled by investors as the above scenario unfolds. If you are unlike everybody else in your family and actually believe in guying things when they are low, this is low.

Third, this compelling value in the preferred market, combined with the fear retail investors are feeling, is exactly what professional investors feed on. Given that prefs have less liquidity than common stocks, you might not have this buying opportunity in the near future.

So, there you go. Use a cheap loan to buy real estate that will drop in value when rates rise. Or buy cheap financial assets that will swell with the cost of money.

Was that so hard?

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July 19th, 2015

Posted In: The Greater Fool

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