PARTICIPANTS
Mark Brisley
Managing Director and Head of Dynamic Funds
Roger Rouleau
Vice President and Portfolio Manager
PRESENTATION
Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape.
Welcome to another edition of On the Money. I'm Mark Brisley, head of Dynamic Funds. We're recording this podcast on Wednesday, January 20, 2021. Obviously, a significant day in the context that the dominant subject of the last few months both politically and economically has entered a new phase. Even as we look forward now with certainty around election outcomes in the US, hope on the pandemic front with positive vaccine news and roll-outs, the fact is we still find ourselves in a current investing landscape of low bond deals and a low rate or lower for longer interest rate environment, both of which continue to pose challenges for investors and their search for yield or income within portfolios.
Given this, it's no surprise we've seen an increase in investor demand for less volatile and higher-yielding assets to diversify portfolios, such as those of today's subject, preferred shares. Preferred shares are an integral part of Canadian investors' roster of investible assets that exist in a variety of structures, each with their own features, benefits, and opportunities, but also a fair amount of technicalities. My guest today brings a lot of experience to the subject and I'm pleased to have him here. Roger Rouleau joined our firm back in 2012 as a member of the Dynamic Credit team, which is responsible for managing over $6 billion in credit-related asset classes, including investment-grade corporate bonds, high yield bonds, and loans, along with floating rate and credit absolute return
strategies, and of course, preferred shares. Roger has more than 17 years of industry experience that includes analytical and portfolio management responsibilities in the corporate bond, high yield bond, and preferred share markets within North America. Roger, thanks for joining us today. I'm going to dive right into our first question, but before we go into the intricacies of the preferred share market's current state, just wanted you to give us an overview of what the benefits are of owning preferred shares, and in particular, this environment.
Roger Rouleau: Preferred shares are what we call hybrid securities, which means they're essentially a mix between equity and debt. What that means to the layman is that they are higher-yielding and can produce a higher potential return than a bond from the same company, but they'll have a lower return and lower risk than the equity. In today's environment, what they represent is an attractive way to increase yield in your portfolio while still sticking to strong and very creditworthy companies. Also perhaps a little word on their structure, this is one of the few segments of the fixed income asset class that actually likes higher rates. Typically lower rates are good for fixed income, higher rates are bad. This is the one corner of the fixed income market that actually prefers the opposite. They really represent an interesting tool in today's market environment.
Mark Brisley: As we think about what we've gone through in the last year, and obviously, there wasn't any area of the market that hasn't been affected somewhat by this global pandemic we've been experiencing, preferred shares were also affected during the market turmoil in the early pandemic phase. We've seen them rally back as nerves have calmed. Can you walk us through a little bit about why preferred shares are rallying right now, and what do you expect going forward in 2021? What's your outlook on the redemption front?
Roger Rouleau: 2020 was really about ebbing credit risk. If you buy a preferred share from any given issuer, you're really lending the money. There were definitely some times in 2020 where you didn't want to lend money to anybody because that was the world we were in. Very high credit risk, a lot of risk in general I would say. The recovery we saw in 2020 was in very large part due to the calming of the credit markets and the realization, if you will, that it's okay to lend money to these companies.
2021 is going to be driven by a shrinking asset class. We see 10% to 20% of the Canadian preferred share market potentially disappearing, essentially being redeemed by the issuers. This we think is going to be a very strong tailwind. Finance 101 is if there are more buyers than sellers, the market goes up, and of course, if there are more sellers than buyers, the market goes down. When you have issuers of preferred shares redeeming hundreds of millions of dollars worth of preferreds, that's a lot of buying, if you will. We think that that tailwind is really going to be driving the market in 2021.
Mark Brisley: When we think about some of the expected redemptions, what does this mean then for retail investors who currently own preferred shares? By that, I'm referring to individual or even preferred share mutual funds or ETFs.
Roger Rouleau: The first impact really is going to be that positive tailwind. If you were invested in an individual preferred share, and it gets called, or you're invested in a mutual fund or an ETF that owns it, then those dollars are going to have to find a new home. Now, obviously, nothing forces any investor from putting that money back to work in preferreds, but some of that money has to stay. For example, if you're invested in a mutual fund that has to be invested in Canadian preferreds, or an ETF that has to be invested in Canadian preferreds, then that money will have to be recycled and there's going to be a positive impact there.
What it also means though is that it's going to be a lot of money in motion. When we look at some of the passive instruments that are out there, such as CPD, or ZPR, these are rules-driven, right? There's no Mark Brisley or Roger Rouleau sitting there saying, "Okay, where's the best allocation of this capital?" They just follow the rules, and the money that's going to have to be reallocated at the very minimum through these products is massive. We're talking hundreds of millions of dollars. It's going to have to flow from these preferreds getting called into what remains in the market. I think the opportunity here is twofold. One is this is going to be positive for preferred, all else equal. As you mentioned today, it's the dawn of a new era, if you will, with President Biden coming in. I say all else equal because who knows what the future reserves, but this is definitely going to be a strong tailwind. The other thing it means is that there's going to be a lot of opportunities to benefit from being aware of this money has to go because obviously if there's hundreds of millions of dollars trying to buy the same things, the owners of those things are potentially very well positioned to benefit from those flows. I think there's going to be a very large opportunity for active managers such as myself to take advantage of these flows for our clients.
Mark Brisley: At the top of the introduction to this podcast, Roger, we talked a little bit about the thirst for income and the search for yields, portfolio diversification, elements of portfolio construction, just a huge subject matter for Canadian investors right now. If we're talking about what factors investors need to consider before buying preferred shares if they're not already exposed in the light of what you've talked about the current market conditions, what are some of the factors that we really should be focused on, and what kind of an allocation should an investor be considering?
Roger Rouleau: The answer to how these fit into your portfolio I think really comes down to risk tolerance. If you look at the performance of preferred shares over the years, it becomes quite clear that they don't play defense very well. When you're constructing your portfolio, it's my view and I think this is sort of financial orthodoxy as well, that you need to have some ballast in there. Historically, that's been your fixed income allocation when you're bought because they're what does well when we go into a recession where there's spiking risks here or there.
When you're thinking about how to use preferred, I think you have to keep in mind the fact that they do not play that defensive role. How much should you have in preferreds and so on and so forth, I think really comes down to what else do you own because you need that defense in your portfolio, and preferreds don't really provide that. Why don't they provide that? They're fixed income instruments, but preferred shares are very sensitive to the credit environment. If you buy a preferred share from a Royal Bank, for example, you're lending money to Royal Bank, so the health of Royal bank becomes important to you. Obviously, in a recession, we start worrying about the creditworthiness of different issuers. That is an exposure that you take on now, and we can debate the actual amount of risk we take if we're lending money to very large financial institutions such as Royal Bank, but regardless that is a risk you're taking. Preferred shares, and I kind of touched on this earlier, do not like lower rates. They like higher rates. This is the structure of how the product's designed. The higher rates go, the higher your coupons go, the higher cash flow goes, and of course, the flip side is the lower rates go, the lower your cash flow. If we were to go into a period of turbulence, both from the credit standpoint, from the rate standpoint, they do not provide a lot of protection.
Why are we talking about preferreds today? That is because what we see over the next coming 12 to 24 months is an economic recovery. With that, I think there's a level of comfort from the taking credit risk standpoint. With yields as low as they are, investors can definitely be forgiven for thinking that the next move in rates is going to be higher. It doesn't necessarily mean it's coming tomorrow because we are in the midst of the vaccine rollout, but at some point, there will be a world in which we'll have higher rates and that would be a positive for this asset class. A good way to get yield and potentially positioned for continued recovery is why we're looking at these, but when you're thinking of your allocation, I think you really need to think of the risk side of things.
Mark Brisley: Before we dive into the questions, we did talk about- there are some technicalities within the marketplace to be aware of. Some of that comes down to the terms we use. We do love our acronyms in this industry. We had a question for you around LRCNs or limited recourse capital notes. There was pretty significant event back in mid to late 2020 with the issuance of an LRCN by Royal as an example. Can you walk us through a little bit about what an LRCN is, why it's relevant to the preferred share market, and has anyone followed since RBC's issuance? Then would we see any of this take place in non-banking financial institutions or non-financial issuers?
Roger Rouleau: In finance, we do love our acronyms, and we do like making things much more complicated than they have to be. I think the way to think of LRCNs is that their preferred shares, they do everything a preferred share does except for two things. One is they pay an interest. That is, of course, in a taxable account for an investor, not a good thing. In a non-taxable and registered account, fine. For the issuers though, interest is much better than dividends. Preferred shares typically pay dividends. From a taxation standpoint for the issuer, they much prefer paying interest. That's one big difference for the LRCN.
The other big difference is that they're sold to bond investors, right? Think of your LRCN as a preferred, structured as a bond. It pays interest because that's what bonds do, not dividends like a preferred. It's sold to bond investors. Bond investors, of course, have deeper pockets and longer arms than preferred share investors. There's a lot more demand for potential LRCN issuance. Without getting into the specific differences between LRCNs and preferreds, those are the two things that really stand out. Royal brought the inaugural issue. They have been followed by a lot of banks and we expect to see more of those. Thus far, LRCN's only been issued by banks. The door is, I would say, very wide open for insurance companies. It's not clear that they will be allowed to issue LRCNs yet, but OSFI has been talking about it and we expect to hear from them soon. Personally, my view is that I wouldn't be surprised if they were allowed to issue LRCNs. But for anyone who can't issue an LRCN, there is a structure that's very, very similar. The distinctions between the two really don't matter and that is the hybrid structure.
Again, hybrid structure is sort of a preferred share that's structured as a bond, the details are slightly different than the LRCN. For the issuer of the LRCN, it's better. If you can do both, you do the LRCN, but they accomplish a lot of the same things. That is in the capital structure of the issuer, they can replace preferreds. The regulators and rating agencies see them as the same, and the coupons are paid in interest, so another advantage for the issuer, and they're sold to bond investors. Very, very, very similar.
We would expect that anyone who can issue LRCNs to issue LRCNs to redeem preferreds, or in view of issuing preferreds, and I would expect anyone who can issue LRCNs to turn to the hybrid market. Why would we see all these redemption activity in 2021 really comes down to the attractiveness of the pricing that's available on the LRCN and the hybrid side. If you think of what would it cost to issue an LRCN and you look at the yield paid on preferreds, you'd see that there's an opportunity here for a lot of the issuers to take them out.
One of the particularities of the structure of preferred shares is that they're redeemable only on the reset date, 80% of the market has the rate reset structure, which means that every five years, you get a new coupon, and every five years you're callable. In 2021, a lot of very expensive preferred shares are callable. I would expect to see a lot of issuance of LRCNs and hybrids come in order to take out the preferred shares or a lot of the preferred shares that are resetting in 2021.
Mark Brisley: We've covered actually quite a bit of ground on redemptions and you just touched there on the outlook towards new issuers. New issuance seems to go in waves or various market cycles. Do you see a possibility for more or a broader new issuance environment in 2021?
Roger Rouleau: Well, I think that if you can issue an LRCN, you issue an LRCN, and if you issue a hybrid, you issue a hybrid. The ones who will look at the preferred share market as of today, let's say, are issuers that cannot access the hybrid market. Now, that could be because they're too small, or it could be because they're not creditworthy enough. To access the deep pool of capital that exists in the bond markets, you do have to have a certain credit quality.
We likely will see some issuers in preferreds, but it's going to be an enlarged part from the smaller less creditworthy issuers. That could change because obviously, we're looking at where LRCNs and hybrids can be issued today, nothing says that difference in funding costs will be there tomorrow. Obviously, if the LRCN and hybrid market sell-off, then the attractiveness to issuers there will be reduced. If the Canadian preferred share market overheats, well, then we could see financing terms at more attractive levels in the preferred share markets than in the hybrid market. As of right now, there's a big gap between the two. I don't see that changing. I have been managing preferreds for over 13 years now. In those 13 years, there definitely have been periods of overheating where there has been bad behavior and financing terms have been extended to issuers at levels that in retrospect didn't make any sense. I wouldn't be surprised if one day we get back to that, but that's not what I expect to see over the next 12 to 24 months, but of course, that can change.
Mark Brisley: Another area that we get a lot of questions about as well, Roger, the chatter, I think maybe it's calmed over the last little while, but the chatter around rates continues, and questions around the impact or the potential for a negative rate environment in Canada or the US, it seems low, but what would be the impact of negative rates in Canada, and the United States on the preferred share market if it were to happen?
Roger Rouleau: Let's talk about the impact first. Then let's talk about in what world would we see this? The impact of negative rates on preferred shares would be very bad. That would be for three reasons. One is, obviously, the initial impact of lower rates whether they're negative or not, but just lower than where they are today is negative on the asset class. That is because, with 80% of the asset class rate reset, lower rates mean lower coupons and lower coupons mean lower cash flow, and obviously, mean lower prices. If we were to go to negative rates, then anyone owning a preferred share would see the expected future cash flows come down.
Obviously, if rates go negative today, that doesn't mean that your coupon comes down right away. That would be the expectation, we're already in a lower for longer type environment. If we were to go to negative rates, then one would expect rates to stay negative or remain low. That's the first-order impact and that's negative. The world in which we feel negative rates are necessary is probably one in which we're worried about credit. What we've seen from Europe and Japan is that negative rates hurt your banks a lot.
Earlier, I took Royal Bank as an example, but it would be the case for any large bank. In a world in which we have negative rates is probably one where we're a little worried about lending money to pretty much anybody, the banking industry as well. Credit worries will also be negative for preferred shares. The third one is outflows. What we've seen is that inflows and outflows can move the preferred share market quite a bit. Liquidity is not always spectacular. In an environment where we think negative rates are required, I would assume there'd be a lot of emotion involved on the investing side. Outflows would probably be quite negative, and this would be consistent with what we saw in March and April of last year.
Negative rates are bad. What would it take to see negative rates in Canada? I think you'd have to see Central Bank of Canada decide that we need a lot of stimulus right now. I think you'd have to see the Bank of Canada have exhausted a lot of the other tools in their toolbox before turning to negative rates. What tools in the toolbox do we see? Bond buying programs. Bank of Canada is buying, going to Canada bonds, provincial bonds, and investment-grade credit bonds. they haven't bought a lot of investment-grade bonds, but we could see them expand that.
The Federal Reserve right now is buying high yield bonds, it's a riskier bond. In order to provide support, we could see the Bank of Canada to do that. They could either increase the size of the buying. They could increase their criteria or loosen the criteria, if you will, increase the pool of bonds that they'd be available to buy. I think we'd see things like this used first before we see negative rates, but then ultimately we could see negative rates. What we've seen out of Europe sort of fits with that narrative in the sense that when things got tough in March and April and May of last year, they cut rates a little bit just to say that they did, but what they really did is they started buying a lot of bonds to provide that support.
I would expect to see the same thing here, but, of course, if we're going to hell in a handbasket, then I think all options are on the table. I wouldn't be surprised to see the Bank of Canada cut rates at negative if that were the case. In my mind, it really is a tool of last resort because as I mentioned, it really hurts your banking industry if you're trying to keep the economic system and the financial system functioning where you need your banks to be able to play the role.
Mark Brisley: Roger, thanks for unpacking a lot of the information that there in those questions. I wanted to refer back to you a commentary that you and your team put out just this past December. You said COVID-related restrictions notwithstanding that December was a happy period for investors across almost all risky asset classes. We saw them moving higher and that preferred shares weren't left out in the cold. We talked about diversification benefits to the portfolio and having preferreds in there. It's a pretty simple question, but your outlook for 2021 seems fairly positive, that you're relatively bullish on investors looking at this as a component of portfolios going forward, particularly if they're not already there.
Roger Rouleau: Mark, there's nothing guaranteed in investing, but I have been investing in preferred shares for 13 plus years now. What I see from my seat is that this is an asset class that over the long-run has struggled to deliver the goods to investors, but when I look into those 13 years, what I see is there's a lot of excellent returns over those years, and then some years that have been harder. Certain environments, certain setup has driven those excellent years and when I look at 2021, what I see is an attractive setup.
Credit risk is being muted if you will, by the solidity of balance sheets, by the involvement of governments and providing support to the economy, by the involvement of central banks providing support to financial markets. Credit risk is not something that we really worry about, rates are low and I think the case can be made that they will either remain low, or they will move higher.
We are rolling out the vaccine and I think a very reasonable view would be that risks kind of get reduced, and we can sort of see a normalization of interest rates, and that would be positive for the asset class. The technical tailwind, I think is going to be with us for the next 12 to 24 months. Having seen this in the past, this is a very strong boost to returns. Of course, then nothing's guaranteed, but all else equal we see a pretty attractive setup for preferred shares over 2021.
I think that when you're looking at your fixed income allocation, you shouldn't have to look at preferreds because the setup looks pretty good and they can provide some attractive diversification and yield enhancement for your portfolio in 2021. This isn't a sort of 20 years "set it and forget it" type allocation, I don't think, but as a one to two-year type tactical opportunity, I think that makes a lot of sense to me and is worth having a closer look.
Mark Brisley: Well, Roger, thanks for taking us through all that. Lots to unpack here. Asset class diversification has become increasingly important, and preferred shares are an effective portfolio construction tool for investors, so really appreciate your insights and joining us today.
Roger Rouleau: Thanks a lot for having me, Mark.
Mark Brisley: Thank you, and thanks to all of our listeners for joining us today. If you would like more information on this subject, feel free to visit us @dynamic.ca where you can find more information about this particular subject and many other relevant subjects to the Canadian investing landscape. Of course, here at Dynamic, we believe the best source of information is to seek out the services of a qualified financial advisor as we stand behind our tagline "Invest with Advice". Thank you for joining us. Stay safe, stay healthy.
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