Although some investors may be concerned about the risk of investing in preferred shares at this point of the equity market cycle, Ryan Domsy argues that these concerns are unfounded. Indeed, because of the low correlation with other asset classes, Domsy maintains this could be an opportune time to use preferred shares as a diversification tool in one's portfolio.
"Preferred shares are at a point where valuations are still quite attractive. We see considerable upside," says Domsy, vice-president, head of credit research and fixed income portfolio manager at Toronto-based investment counselors Foyston, Gordon & Payne. The firm is sub-advisor to the $103.6 million Evolve Active Canadian Preferred Share ETF (DIVS), which was launched in September 2017 by Evolve Funds Group in Toronto. DIVS is managed in a similar fashion as FGP Preferred Share, a pooled fund available to high-net-worth and institutional investors that Domsy and his team have managed since December 2015.
"It's not just about the market cycle for preferred shares themselves, but how they react when other types of securities are in weak points of their cycles. When you see sell-offs in equities or bonds, preferred shares have low correlations and the market cycles are not perfectly lined up. This is a positive feature of preferreds," says Domsy, a 10-year industry veteran who graduated in 2008 with a master's degree in economics from Queen's University and joined FGP in 2010. The asset class has a near-zero correlation with bonds, Domsy notes, and correlations of 30% to 40 % with equities.
Preferred shares should be used as a complement to bonds in an overall portfolio, Domsy adds. "Because of the way that preferreds are constructed, they react fairly favourably when interest rates are rising. They are a very good offset to holding a portfolio of pure bonds," says Domsy. "We have seen over recent history that preferreds have had positive price movements when interest rates have risen. But that's not to say that all preferreds go up when rates go up. The market is very complicated and each security can be very different. Some would actually rise, while others will potentially fall. Because of the nuances of each security, it's very important to have an active manager who doesn't just know the company they are investing in but knows all of the attributes of each security." One bank, for instance, may offer so-called "rate-reset" preferred shares, or perpetual shares or so-called "floater" shares and each would perform differently in a rising rate environment.
It is commonly believed that central banks will keep raising short-term rates, which is expected to produce modest capital losses in some bond portfolios. "One of the benefits of preferreds is that they will help offset that [environment]." Domsy and his team also manage the $23.8 million Evolve Active Core Fixed Income ETF (FIXD), which uses predominantly government and investment-grade corporate bonds but also some preferreds, high-yield bonds and convertible bonds.
"In a rising rate environment, a preferred allocation will give you capital preservation, potentially a bit of a capital gain and a very solid yield," says Domsy. Currently, preferreds are paying dividends that are about 2.0 to 2.5 percentage points higher than comparable bonds. Dividends are tax efficient because they are eligible for the dividend tax credit. In contrast, interest earned from bonds is fully taxable.
As for the potential downside, Domsy acknowledges that the asset class took a hit in 2015, mainly because of misinformed retail investors who panicked and sold their shares. "There was a lot of confusion because people didn't know what they were holding because there are such differences from one preferred to the next. For instance, there are 21 Bell Canada preferred shares outstanding and every issue has slightly different rules," says Domsy, noting that in 2015 the benchmark S&P/TSX Preferred Shares Index fell 15%. "It goes beyond making an investment in a company. It means understanding the specific issues of any single line."
Domsy argues that currently the risk of another meltdown is minimal, because the broader preferred market has not fully reflected the move higher in interest rates over the past few years and rates are likely to keep rising. "In that environment preferred shares will continue to see significant interest and people will likely keep buying the asset. That should help with price stability," says Domsy. "Additionally, the preferred share market has evolved over the last few years. It used to be predominantly retail-focused. But since 2015, you have seen significant participation by institutional investors. I would expect this would lead to more stability and less of those panic scenarios."
Indeed, the market is now crowded with eight ETFs and 11 open-ended funds, lead by the largest of the pack, the $1.7-billion Horizons Active Preferred Share ETF (HPR).
From a strategic viewpoint, Foyston, Gordon & Payne is somewhat different from its competitors because it relies on a bottom-up process. The benchmark S&P/TSX Preferred Shares Index, which has a market capitalization of about $76 billion, includes 236 individual holdings. In contrast, Domsy notes that the FGP fund and DIVS hold about 65-70 names each.
Domsy's team relies on the FGP proprietary credit process to distill the universe down to a much smaller number, with a focus on identifying and quantifying the risk of a given holding to determine if a security is undervalued. While some of the valuation measures are price- and yield-related, the nuances of a particular security also come into play. "For example, if you are looking at floating-rate preferreds, you could have T-bill-based securities or prime-based preferred shares, and both will react differently in various interest rate environments," says Domsy.
"Metrics are involved in the process, but that changes depending on what type of company we are investing in," adds Domsy. "You need to properly understand each business and the risks of the industry it operates in. It's very different being a large player in a fragmented market versus a large player in an oligopolistic market. We need to make sure we understand the nuances."
On average, the portfolio is yielding 4.6% before fees, or about 3.8% on a net basis.
Although FGP is a private firm and Domsy is prevented from discussing names in the portfolio in detail, he acknowledges that some holdings include preferred shares issued by 
Enbridge (ENB) and Toronto-Dominion Bank (TD). "There's been some weakness in Enbridge's preferreds, but we think the company is entering a phase that will see improvements in the risk profile. That will likely lead to increases in the market price that are [proportionately] better than the index." TD Bank is another favourite because it has the lowest risk profile among Canadian banks. "I like the diversification of its product lines. Overall the company is very well run."
Going forward, Domsy is confident that preferred shares can offer a buffer against an equity market correction or continued weakness in the bond market. "Preferred shares are a much more attractive place to be right now," says Domsy, noting that where there are opportunities FPG is using preferred shares to bolster portfolios, protect capital and generate yield.
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