Does your portfolio need preferred shares?

Christian Charest: For Morningstar, I'm Christian Charest. I'm here today with Jean-Mathieu Gareau of Intact Investment Management. He is the co-manager of National Bank Preferred Equity Income.

Thank you very much for joining us today.

Jean-Mathieu Gareau: Well, thanks for having me.

Charest: You are a preferred share manager. Preferred shares are not really considered a major asset class by a lot of people. So for our viewers who aren't too familiar with them, can you start by explaining how preferred shares work?

Gareau: Yeah, definitely. So preferred shares are a hybrid between debt and equity. It's junior to all of the debt instruments in the capital structure, but it ranks senior to equity. It's issued at a par value of $25 and it pays a coupon in the form of a dividend.

Charest: And it pays perpetually.

Gareau: For most of the market yes, 95% of the products are perpetual.

Charest: What's the size of the preferred share market in Canada?

Gareau: The par size is about $70 billion, but given that a lot of these issues trade at a discount the market value is roughly $55 billion.

Charest: And who are the issuers, typically?

Gareau: Mostly from financial issuers. I would say the big six banks and the four major Canadian life insurance companies, they account for 50% of the issues; add in another 10% from other financial issuers like Brookfield Asset Management or Fairfax. Then you have some utilities, like Fortis and Emera are 10%, and TransCanada, Enbridge, AltaGas in the energy segment for 15%. The balance of it would be the telecommunications sector and the consumer sectors.

Charest: For the typical investor, what role do preferred shares play in a portfolio?

Gareau: I think in the past it would have been to generate extra income with relative stability in the portfolio. But in the past two years the nature of the market changed and preferred shares now, on top of having a role of providing very good tax-efficient income, they also react differently from traditional fixed income products, and they are expected to do well if interest rates start to go up. And because of that I see them as having a role of hedging a fixed-income position in the portfolio.

Charest: And is there a recommendation as far as the size of allocation that we should have?

Gareau: It varies depending on the need for income. But also I would argue that depending on the size of your fixed income portfolio and the duration of your fixed income portfolio, that hedging component would vary, and this is why I'd say for a five-year duration portfolio, I'd say 10% to 15% in preferred shares is adequate. I would specify that [I mean] 10% to 15% of your fixed income portfolio, not the total portfolio.

Charest: Preferred shares have had a great performance in the last couple of months. But if you look at the longer term numbers, it's not quite as rosy. How do you describe the performance overall?

Gareau: We don't really have to go long term to understand that. Even for the year to date, preferred shares are down 3.5%. As you mentioned we had a big rally in the last two months; we're up 14.5% from the trough of 2016, so that was great and it was based mostly on two factors. First, interest rates grinding a little bit higher, and second, a compression of credit spreads, which really helped support the market. If you look back over a five-year period, we've seen that preferred shares had a crisis of their own and this is why on an annualized basis the total return was minus 1%. And if you want to stretch even further in the past, over the last 14 years, we've had two crises in the preferred shares market, and this is why the total return on an annualized basis is only 2%.

The most important vectors to explain the performance of preferred shares would be interest rates and the direction of interest rates; credit spreads -- when credit spreads widen, it's negative, and if they tighten it's very supportive for preferred shares -- and other specific events like credit downgrades, new issues, and even fund outflows that would dictate movements in the short term but still impact the performance.

Charest: What can investors expect going forward?

Gareau: I think you need to start off with the dividend. The dividend yield is roughly 5.5% today. But I am of the opinion that credit spreads are too high for the asset class if you compare to other instruments in the capital structure. So if we have stability in the market, it's reasonable to expect a compression of credit spreads that would add, call it 100 or 200 basis points of price appreciation through the years. So 5.5% plus 2% you are at 7.5% for the next several years. Obviously it's not going to be linear, it can be volatile but on average that's what I would expect.

Charest: The Preferred Share Fixed Income Category isn't one of the largest fund categories in Canada. There are only 10 unique mutual funds and seven ETFs that compete in that category, excluding multiple versions of the same funds. What sets your fund apart?

Gareau: I would say that there are a couple of things that I think we do differently from others. The first being that we don't really try to forecast interest rates. We're not interest rate experts; rather, we are preferred shares experts. So we are really adopting an approach where we focus on choosing the best preferred shares -- stock picking approach, if you will. And so we divide the market into sub-categories of products that are expected to behave similarly and focus on picking the best products in each of these sub-categories.

Another thing that would set us apart, I'd argue that we have an internal benchmark construction methodology. It's a benchmark that focuses on quality and it's something that really helped us add value over the years. The last thing would be the active approach that we have. We don't really take an interest rate view, but we do manage with a balanced approach and we can switch if we have visibility on a certain structure doing better than other structures. So because we have a very balanced approach and a quality approach on some of that, that helps us stabilize returns over time and gives us greater comfort in that strategy.

Charest: Mr. Gareau, thank you very much for sharing your expertise with us today.

Gareau: You’re very welcome.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.