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ALWAYS CONSULT YOUR INVESTMENT PROFESSIONAL BEFORE MAKING ANY INVESTMENT DECISION

August 27, 2019 | The Unloved

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.

Steve & his squeeze have managed turn $100,000 in net worth into one million. The household income is $200k, and they own real estate with a mortgage equal to one year’s earnings. That will be offed in six years.

How’d they do it?

Two things. First, real estate: “This was mainly possible as a result of our move from Vancouver to the North Okanagan. We were able to buy a new-build 4 bedroom townhome for less than $400k three years ago,” he says. It’s amazing what happens when you liberate yourself from the land of $2 million crap houses.

Second, they learned how to invest: “I started off recklessly investing in individual stocks and over the years have adopted your balanced and diversified portfolio advice. We skew a little more aggressively with a 70% equity / 30% fixed mix. Our plan is to continue saving, investing and reach our goal of $2 million in the next decade. That would allow us both to considerably reduce our working hours and make more time available for our outdoor pursuits/family.”

BTW, here’s the MSU: “Long time reader of your daily blog. I love the combination of humour, sarcasm and advice. Thank you and your team’s ongoing contributions. The fact that your blog is completely ad free is a breath of fresh air.”

Okay, but there’s a problem. Preferred shares. Like many who come to moan about lost capital value on prefs as interest rates dropped, Steve has trouble staying in an asset class that’s plopped. His question:

“Going forward, is it reasonable to expect a rebound in preferred shares if interest rates stabilize or increase? Or is it more likely that long-term low interest rate environment makes this asset class one to avoid. I do believe you said you own preferreds because they provide diversification and a counter balance to other asset classes.”

If you didn’t know, preferreds are a hybrid between stocks and corporate bonds. Like stocks, they pay dividends, not interest. Good ETFs based on prefs hold a basket of securities from the best bluechip issuers such as banks, utilities and insurers. Like stocks they constitute an ownership position in those companies, but like bonds they’re considered fixed income, kicking out a regular stream of cash. These days that amounts to the better part of 5%. Sweet.

The Canadian pref market is dominated by ‘rate resets’ which adjust every few years based on the central bank rate. So when interest rates rise, so do preferred values – a nice offset to bonds, which drop when the cost of money increases. But despite the market price of preferreds, they’re mostly held for yield. A lot of people don’t understand this, since they think everything in their portfolio should go up in price. But that never happens in a fully-diversified account.

As mentioned, prefs pay dividends. Bonds (and GICs) pay interest. Big difference in tax treatment, thanks to the credit given dividend investors. For example, if a preferred share ETF pays you 5%, then a bond of GIC would have to produce 6.5% just to equal it. But both of those, as we know, deliver peanuts in comparison. Like I said, buy them for yield.

Now what about price? When interest rates rise, prefs do, too. But lately rates have plunged. Prefs have lost a quarter of their value along the way. So will that change?

Of course. The yield on government bonds has been pushed into the ditch by the Trump trade war, with the yield on a US 10-year Treasury cascading from 3.2% before Christmas to 1.5% now. Ditto in Canada. Prefrreds went for the ride, even though they continue to pump out that dividend. Yes, if Trump blows the world up and a recession ensues, yields could edge lower. But the odds of that happening are slim (to none). And eventually bond yields will restore. Prefs will track that – which means if you believe in buying low, take note. This is low, baby.

Hey, here’s my fancy portfolio manager buddy Ryan who dropped in to borrow my chamois. So, how would you answer Steve?

“I’ve been covering the Canadian preferred share market for over 15 years and without fail, bad years have been followed by strong years and I believe this time will be no different.” He says. “While my timing may be off, I believe strongly that bond yields will ultimately rise leading to a recovery in prefs.”

So what to do now?

“First, plug your nose and take your medicine. Prefs are out of favour but don’t let your emotions drive your investment decisions and sell after a 20% drop! Second, sit back and clip the 4-5% dividend yields while you wait for the recovery. Third, be proactive and take advantage of this drop by rebalancing your portfolio and adding to these current stinkers. That’s what I did last week in my own personal account. For clients we’re doing exactly this by beginning to trim our strong performing bond ETFs and adding to our preferred share ETF.”

As usual, R has a chart in his pants:

 

“Look at this chart. It’s a beauty and it perfectly illustrates why we’re doing this! The green line tracks the relative performance of Canadian prefs (CPD-T) to Canadian bonds (ZAG-T), overlaid with the US 10-year bond yield. Note how when government bond yields (in this case the US 10-year treasury yield) is rising prefs outperform bonds (rising green line). Conversely, when government bond yields decline, bonds outperform prefs (declining green line). So prefs in effect provide a hedge on our bonds, which have been doing great. Since I believe we’re close to the bottom in yields we’ve been taking advantage of the strength in bonds by trimming them and adding to the beaten up prefs. Will our timing be perfect (probably not), but we’re getting to extremes on government bond yields, and they ultimately will recover along with pref prices.”

So, let’s summarize: preferred shares deliver a steady, sexy cash flow equivalent to a 6.5% bond or GIC, thanks to the tax credit. They represent a stake in some of the best companies in the land, which will never flounder. There is zero credit risk. They’re destined to rise in value as interest rates move. Right now we’re at historic lows for rates and history tells us they’ll not remain. If you believe in buying low and selling high (instead selling low and moaning) here ya go. Low.

A balanced and diversified portfolio should have about 15% in unloved preferred shares. Seriously. Be a rebel.

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August 27th, 2019

Posted In: The Greater Fool

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