Redwood Floating Rate Preferred Fund

2016 Performance Summary

 

Preferred shares reversed the downward price action in March, putting up their first monthly gain in more than 6 months. The S&P/TSX Preferred Index (TXPR) down -6.9% YTD, the S&P/TSX Preferred Ladder Index (TXPL) down -10.5% YTD and the Redwood Floating Rate Preferred Fund is only down -4.8%.

Our view remains that the sell-off over the last 15 months in the preferred share market presents a very attractive opportunity for investors looking for dividend income streams from securities with substantial upside in the event of normalization of the interest rate environment to higher levels.

The Fund paid a regular $0.04 distribution for an annualized market yield of 5.90%.

 

Fund Positioning

 

We remain: 

  • Defensively positioned – with focus on securities with increasing cash flows and strong balance sheets while maintaining an awareness of the time horizon and the cyclical nature of interest rates.
  • Overweight the recent new issues from that have both high coupons and high reset rates – these are very safe and attractive securities
  • In the near-term, we maintain our underweight position of deeply discounted rate resets but maintain a shopping list of securities in this group we like, as our outlook for moderately higher interest rates in the coming years will result in better total returns, given their potential for price appreciation.

Changes we made:

  • Reduced overweight position of cash to participate in rally –>30% to 13%.
  • Increased exposure to floating rate/rate resets and decreased exposure to perpetual preferred securities.

This positioning has resulted in a slight underperformance in March relative to the market.  While we are excited to see positive performance in the preferred space, we remain cautious as the previous two +10% rallies in both October and December have been followed by material sell-offs (as seen in the chart below).

We are happy to miss the initial rally of a sustained long-term price appreciation in order to ensure the rebound is sustainable and real – we do not want to chase short term rallies.

 

Preferred Share Market Overview

 

  • Preferred shares have been challenged over the past 15 months as CDN GOV 5 YR Rates have decreased by 42%.
  • Resets make up 66% of the Canadian Preferred Market and 90% of the issuance over the last twelve months.
  • Investor base of preferred shares is changing from retail to institutional. We are starting to see increased institutional interest as these “smart money” investors search for attractive yield pickup, significant price appreciation upside, and high reset spreads. There is a belief that we are at a market bottom (Chart 4).
  • New issuance will remain healthy, but not excessive. Last twelve month average is $7.7bn with a peak of $12bn in 2014. As a result, there will be a lower level of redemption as we expect extensions from most issuers.

There is more downside protection in recent new issues; higher reset spreads and/or floors. Here are some we like:

 

Macro Overview

 

The rebound in the preferred share market has been driven by 3 key factors:

1) A rebound in the Canadian Gov. 5-year rates. There was a 66% move off the February 10th low of 0.488, to its March high of 0.811 before settling at 0.675 on March 30th 2016. There was a pullback from the high, so we remain cautious but optimistic.

2) There has been a significant decrease in the probability of a rate cut. Looking back at the charts high of 82% in January 2016, the probability of a rate cut has decreased to a YTD low of 7.6% on March 30, 2016.

3) Crude Oil traded down to a low of 30.76/bbl in 2016, but has since staged a rally surging 35% off the low this year.

What is causing this?

  • The recently announced budget will keep the BoC from lowering rates in the near term. This has caused a positive reaction in oversold preferred securities.
  • There were few surprises as the projected deficits of C$29.4bn in FY16/17 and C$29.0bn in FY 17/18 were consistent with market expectations.
  • The composition of spending was also in line with views going into it, with C$11.3bn in infrastructure spending –> positive for the economy.
  • The government estimates a 0.5% add to growth in each of FY16/17 and FY17/18 – updated forecasts project 1.4% in 2016, 2.4% in 2017
  • Additionally, manufacturing and retail sales reports for January both came in strong earlier this month, with manufacturing sales posting a 2.4% volume gain, while retail sales registered a 2.1% gain

Overall, signs are pointing to a continuing trend for growth – (See Chart 5)

 

Data Source: Bloomberg, Redwood Asset Management as at March 31, 2016 unless otherwise specified.

 

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