Choosing a fixed or floating option for your rate reset preferred shares can impact how much you reap from that investment – and the biggest determining factor may be your outlook on interest rates.
Investors holding rate reset preferred shares have a big decision to make every five years – do they want to go fixed or opt for a floating rate?
All rate reset preferred shares have slightly different iterations, but the most common is a 5 year reset period. At that point, many offer the ability to opt for a floating rate coupon instead of simply locking in at the current rates for another five years.
That floating rate coupon or interest payment would reset every three months at the 3-month T-bill rate plus your credit spread, while the 5-year reset is usually set at the five-year government of Canada rates plus a set premium for the issuers’ risk, which gives you some extra yield above and beyond that government rate.
So how can you know if it’s better to lock in or to take chance on the floating rate?
In most cases, the decision will be based on what you think will happen to interest rates.
If you choose to lock in today at 5 per cent for the next 5 years, it’s because you think that’s going to be a good rate for the next 5 years. But if you thought rates were going to go up — and go up soon — you would probably prefer to go floating, because every 3 months your reference rate is going to adjust for any underlying changes.
Let’s say you are trying to decide between fixed and floating, where fixed would be the 5-year Canada rate at 0.6 per cent plus a fictitious 1.5 per cent for the corporate risk involved. You would be locking into an annual coupon rate of 2.1 per cent for the next 5 years.
But if you decided you wanted to go floating, you’d be opting for the 3-month T-bill rate which is about 0.4 per cent plus that same 1.5 per cent, which would give you 1.9 per cent today. If rates rise, you have the potential to get a higher payment. That means that while you may be behind today, if rates did rise within the 5-year period, you would come out ahead. If rates fall, you’d be further behind.
Typically, rate resets are based on the relationship to the 5-year government of Canada rate and generally track those rates pretty closely. But there are various other market impacts that could move their prices around, just like with any investment. Those may include supply, demand, risk in the markets, inflows and outflows and popularity of that particular issuer.
In general, however, it’s good to keep in mind that the wider the discrepancy between the 5-year and your very short 3-month T-bill, the more likely it is you’re better off going fixed rate.
But at times when the difference between the two reference rates is very close and there’s a potential of rates rising within the next 5 years, you’d be better off floating – especially during times of historical all-time low interest rates.