Preferreds quell queasiness of bad politics

Posted on: December 18, 2011 in: Canadian Equities, Dividends, Economic Growth with 0 comments

CLAYMORE S&P/TSX CDN PFD-COM Ticker: CPD / TSX

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Pity the equity markets. Over the last several weeks, in fits and starts, they have shown signs of cautious strength in response to signs of economic growth and new pro-growth policies in several major markets. But each time, they have been knocked flat by another wave of nauseating politics. This struggle between opportunity and risk poses challenges for investors.

For many investors, the instinctive response is to run for the safety of bonds, especially long-tenured government treasuries, (assuming the sovereign is solvent). As profitable as that trade has been this year, it would be a mistake to stay with it now.

An exchange-traded fund of long government bonds, iShares XLB/TSX, has returned in total 16.5% in the year to date. Most of that has come from capital gains, as demand from safety-seeking investors has pushed prices higher, leaving yields razor thin.

However, the only thing keeping bond yields from rising (and prices from falling) is the fear that the Euro currency will disintegrate and plunge Europe into a recession. True, the Europeans have been incredibly inept in dealing with their self-inflicted crisis. But disintegration is an extreme scenario.

More likely, the Europeans will muddle through, much like the U.S. Congress did with its one-minute-to-midnight debt ceiling showdown last summer. Last week’s European Union proposal for tougher, harmonized financial regulations and stricter pan-Euro fiscal policies was a step in the right direction. Progress on this plan will send bond prices tumbling as investors rush back to equities.

Eventually, economic fundamentals will reassert themselves: high corporate profits, positive industrial growth, lower unemployment and improved consumer sentiment in the United States; lower inflation and a transition to easier, expansionary money policies in Brazil, Australia, India and most significant of all, China, the world’s second-largest economy. Then perhaps, equities will finally shake off their dismay.

Until then though, investors’ manic depressive behaviour will continue. There is no cure for it, but to control the symptoms, investors could consider preferred shares, that class of security that exists somewhere between bonds and equities. Preferred shares offer the potential of some capital gains when equities rise while partially protecting against setbacks.

There are a few exchange-traded funds holding Canadian preferred shares. The oldest and biggest is Claymore’s CPD/TSX.

Comparing CPD to an ETF of quality corporate bonds like iShares’ XCB/TSX shows that CPD actually has a lower volatility of about 4.3% annualized versus 10.5% for XCB and 16.5% for iShares S&P/TSX Composite (XIC/TSX) ETF. Where the bond ETF is negatively correlated to the Composite (one zigs, the other zags), the preferred ETF has a low but positive correlation (one zigs, the other usually zigs too but not by as much).

On returns, the bond ETF is the clear winner this year with a total return of 7.1% while CPD has returned 3.9%. But this trend should revert to its longer-term mean. Over the past three years, CPD has returned about 14%, outpacing XCB by about 4%. On top of that add the advantage of CPD’s dividend tax credit.

CPD holds about 150 different preferred share issues, though unique issuers number about 32. Brookfield and the big five banks make up half the holdings by weight. All the holdings are of high credit quality, similar to the bond ETF.

One other ETF of preferreds is Horizons’ HPR/TSX. It is just a year old with a much smaller asset base but what sets it apart is its active management style. The preferred share market is neither broad nor deep. Relatively few issuers and illiquid trading leaves bid/ask spreads wider than in, say, common shares. To correct for this, HPR uses some discretion in deciding what and when to buy. CPD, on the other hand, sticks close to its benchmark index.

HPR’s year-to-date is 5.3% or 1.3% more than CPD, though some of that difference comes from HPR’s holdings of some U.S. preferreds from issuers like American Express and General Electric. Quality-wise, its holdings are comparable to CPD’s though of course, dividends on the U.S. holdings do not receive preferential tax treatment.

Both ETFs however are decent antidotes for the queasy few months ahead.

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Chart courtesy of Bloomberg L.P. Click on Chart for Larger Image

archerETF Metrix 15 Dec 2011
Ticker/Exchange CPD / TSX
Name CLAYMORE S&P/TSX CDN PFD-COM
Categories Equity / Canada / Large-cap / Financial
Total Holdings 150 Issues (32 Issuers)
52 Week High 18.71
Recent Price 17.11
52 Week Low 16.8
Avg Daily Volume 175,089 shares
Avg Daily Volume ($) $ 3.0 Million
Total ETF Assets $ 756.3 Million
Allocation to 10 Largest Holdings 11.05% (74.5% to top 10 issuers)
ETF Annual Fee .50%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 4.24%
Correlation to S&P TSX Comp. 11.20%
Return to Risk Ratio 0.98
Beta to S&P TSX Comp. 0.35
Price-to-Earnings Ratio N/A
Use of Leverage No
Use of Futures No
6 month Return .44%
1 Year Return 5.59%
3 Year Return 14.23%
Dividend Yield (TTM) 4.84%

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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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