Thread by @CadPrefs

Many people think of preferred shares as a standard tool that is for income only, sort of like a flat head screwdriver. We see preferred shares as a multiheaded screwdriver with many different trades. Here is a thread on one.

Investors are concerned about the fixed income portion of their portfolio with interest rates at all-time lows. How can they hedge the interest rate/duration risk?

One way is to use interest rate options, but that involves constantly rolling options, which detracts from returns and is time-consuming. Or investors could shorten the duration on their portfolio but that leads to lower yields.

This is where floating-rate preferred shares come in as a trade. Many investors look at floating-rate preferred shares and think their duration is the time period until the next coupon date. This assumption is fair if we are in a flat interest rate environment.

But when we move to increasing or decreasing interest rate environments duration momentum takes over. We calculate that the average floating-rate preferred share duration is -44.

It is negative because preferred shares that are priced off government bond yields move with the yields, where corporate bonds move in the opposite direction of government bond yields.

Floating-rate preferred shares are a string of call options on interest rates that investors do not have to worry about rolling. The best part is floating-rate preferred shares will pay you a 5.3% yield, so they will no detract from income needs.

During the last rising-rate environment from 2015 to 2018, the TMX Canada Universe Bond Index was down 4% when rates increased from 0.5% to 1.5%. Compared to floating-rate preferred shares that were up 30%.

If we assume the average Canadian bond portfolio matches the TMX Canada Universe Bond Index, then the portfolio's duration is 8.5. To cut the duration in half only 8% of the fixed income portfolio needs to be put into a basket of floating-rate preferred shares.

The duration reduction from preferred shares leads to the fixed income portfolio's yield improving from 2.60% to 2.95%.

What we also like about floating-rate preferred shares right now is that they can be a substitute to minimum floor coupon preferred shares. Investors are hiding out in minimum floor coupon preferred shares because of their income certainty.

We would argue since the BoC does not want to take interest rates negative floating-rate preferred shares' income is just as certain.

Minimum floor coupon preferred shares are giving up 1.70% in yield compared to rate reset preferred shares, floating-rate preferred shares are only giving up 1.15%. A cheaper solution for income certainty.

Investors should start to see now that there are more to preferred shares than just providing income.