Thread by @CadPrefs

With the Monterey Policy Report being released by the BoC there was one item that we found under-reported and has been something we have been following since the July report, the change in the neutral rate.

For preferred share investors the lowering of the midpoint of the neutral rate from 2.75% to 2.25% is a significant blow. We do not expect the BoC to get back to the neutral interest rate and looking at recent history under Poloz the closet was a full 1% below the neutral rate

at 1.75%. Even the Parliamentary Budget Office does not think we will get back to the neutral interest rate their forecast earlier in the month was a 1.25% overnight rate in 2025.

Looking back at the move under Poloz to 1.75% gave the BoC wiggle room to the lower bound of 50BPs, which if the Canadian economy really heated up in 2019 could have been used. We expect Tiff to have the same approach which means the best-case scenario is a 1.25% overnight rate.

Historically the 5-year yield has averaged 45BPs over the overnight rate, which means that we expect the 5-year yield to be around 1.70% by 2025. The implications for the preferred share market of a 1.70% 5-year yield are significant.

It effectively means that any preferred share that was issued when the 5-year yield was over 1.70% will not be called because it will be cheaper to leave them on the market than when they were first issued.

This means that if the preferred share that you own was issued before October 2014 or between September 2017-February 2019 the chances of them being called are now effectively zero.

The preferred shares issued before October 2014 averaged a 5-year yield at issuance of 1.70% and the September 2017-February 2019 average 2.05%. Under the old neutral rate of 2.75% and using earlier assumptions our future 5-year yield estimates would have been 2.20%,

which kept the entire preferred share market in play to be called. With the change in neutral rate, 67% of the preferred share market now has a close to zero percent chance of being called.

The neutral rate change will affect the best-case scenario for dividend income, especially the 40 rate reset preferred shares that reset or were issued between September 2017-February 2019.

For the 40 rate reset preferred shares in our best-case scenario of a 1.70% 5-year yield will see their dividend decrease by 8%, while the rest of the rate reset market will have an average increase of 17.6%.

A group that we track are what we call second reset preferred shares, these are preferred shares that have already reset recently under Covid-19 or back in 2015-2016.

In our best-case, this bucket of second reset preferred shares will see dividend increases of 31.2%, with one increasing by 76%. The second reset preferred shares don't even need rates to rise to maintain their dividend.

If we see the 5-year yield normalize to its historic spread, leading to a 0.70% 5-year yield, the second reset preferred shares will maintain their average yield of 6.8%.

One final thought that must not be forgotten is the new lower bound of the neutral rate is 1.75% and is below the BoC's inflation target of 2%, which is interesting. Happy Hunting!!!