July 18, 2015 Enbridge Rate Reset Preferred Shares (see correction)

An Enbridge Inc. rate reset preferred share has been added to our list rated (higher) Buy at $19.27. At that price it yields 5.7% but only until December 1, 2019. At that point the dividend will be reset to yield 266 basis points plus the 5 year government of Canada bond yield. If the government yield were to remain at today’s 1.15% (correction, should read, 0.69%) then these shares would reset to yield 3.81% (correction, should read 3.35%)on $25.00 or 4.9% (correction, should read 4.3%) on today’s price of $19.27.

Rate Reset preferred shares have recently suffered losses. The idea of these shares was that investors would be protected from sharp declines if interest rates rose materially because the rate would reset after five years. However, what happened was that interest rates continued to fall. But the market yield on new and existing rate reset preferred shares did not fall as much. The spreads over the five year bond increased. The result is that rate reset preferred shares that have reset recently have done so at dividends that are less than the market yield on new $25.00 rate reset preferred shares and therefore are worth materially less than $25.

The fear now, is that even those rate reset preferred shares that have three or more years to go before they reset will suffer the same fate. This could happen if interest rates on the 5 year Canada bond continue to fall or refuse to increase and if in particular, the market spread on these rate reset preferred shares is less than the spread at which they will reset.

I believe those rate reset preferred shares like the Enbridge one that we have added that have three or more years before the reset date have likely already priced in the scenario of a reset below the market yield at that time and that therefore their is now a reasonable chance that these shares can offer a capital gain if turns out that the reset yield is closer to a market yield than is currently expected.

Note that the RioCan rate reset preferred on our list now has less than 9 months before its reset date and so it is now running out of time for interest rates to increase or the market spread to decrease. This means there is less chance for it recover towards $25.00.




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