What about Preferred Shares?

With rising interest rates, some investors should re-consider preferred shares. This post describes what preferred shares are, the different types of preferred shares, and how they might be used by investors.

What are Preferred Shares?

Preferred shares generally have preferential rights to dividends over common shareholders. However, many preferred shares limit the exposure investors may have to capital appreciation. The result is many preferred shares trade more like fixed income securities such as bonds, rather than the common stock in the underlying company. Technically though, preferred shares represent ownership in a company’s equity rather than a debt obligation.

Types of Preferred Shares

There are a few different types of preferred shares including perpetual, variable, and rate-reset preferred shares.

Perpetual preferred shares (sometimes referred to as “fixed-rate” preferred shares) are preferred shares paying a fixed dividend. Typically, perpetual preferred shares trade with a similar duration as a long bond, but most also have call features that cap the value they may appreciate before getting redeemed by the issuer.

For example, many perpetual preferred shares are issued with a par value of $25.00 and a right for the issuer to redeem them at a strike price around this level in the future (such as $26.00 after 5 years). The call feature protects the issuer from falling rates.

Variable preferred shares pay dividends based on an underlying reference rate, such as bank prime rates, Bank of Canada benchmark rates, or banker’s acceptance rates.

Rate-Reset preferred shares pay dividends based on rates that may fluctuate over time based on certain conditions.

There are many different types of preferred shares, and retail investors should generally avoid investing in preferred shares since they require you to read the details of the preferred share prospectus. The liquidity of preferred shares are usually much lower than the associated common shares. So, not suitable for investors used to placing market orders.

But, for the right type of investor (sophisticated DIY investors), preferred shares are a valuable tool.

Tax Benefits

Since preferred shares pay eligible dividends, they are better for tax than other fixed income securities such as bonds, and even REITs. Since, the tax rate on dividends is lower than the tax rate on interest. For the same yield, investors will get more after-tax returns by taking dividends from preferred shares than from interest on bonds.

A Basic Preferred Share Strategy

Investors who follow long-term investing strategies usually maintain low transaction costs and hold their portfolio investments for decades (oftentimes for their entire life). This means, the composition of their portfolio rarely changes.

These types of investors, if they also carry some fixed income allocation, should consider perpetual preferred shares. Blue chip Canadian companies such as Brookfield and its associated subsidiaries, Power Corporation and its subsidiaries, Canadian utilities companies, George Weston and associated companies, and Canadian banks all have perpetual preferred shares outstanding. Using a website that will rank preferred shares for you such as CanadianPreferredShares.ca makes research a lot easier.

Investing in some perpetual preferred shares will likely increase the yield on your portfolio. And, if held in a non-registered account, preferred share dividends will provide better after-tax returns compared to bonds of the same issuer. The main differences between preferred shares and bonds is their priority when cash-flow is disrupted and when the company is being liquidated.

Perpetual preferred shares will drop in value when interest rates rise. And, keep in mind that perpetual preferred shares will trade with a duration like a long-term bond. So, when rates rise, perpetual preferred shares will fall farther compared to shorter term fixed income securities.

Ranking Preferred Shares

Many preferred shares get a credit rating like bonds do. DBRS rates Canadian many Canadian preferred shares. Most of the larger issuers are rated, but some smaller issuers and less active issuers are not. Consider E-L Financial. This company has a market cap of almost $3 billion, is controlled by the Jackman family, and is not an active capital markets issuer. The public float is smaller, so rating agencies like DBRS don’t rate it. However, if investors examine the balance sheet of E-L Financial, they will find a highly liquid portfolio. Since E-L Financial is obscure, and their preferred shares aren’t very liquid, their yield is also higher. There are opportunities in preferred share markets for individual investors who can understand the terms and risks of various preferred shares.

What is the Call Price?

When considering perpetual preferred shares, investors should also look at what price the shares might be redeemed. This is an important consideration, since if interest rates go very low, the perpetual preferred share may get “called away” by the issuer. Investors looking for some capital gains, might also want to fish for preferred shares that are trading much lower than their par value or call price. For example, look for perpetual preferred shares trading at under $20 per share when their par value is $25. This way, if interest rates rise, more of your return will come in the form of capital gains.

Beware of Complexity

Preferred share investors should consider the complexity of the preferred shares they are analyzing. Many preferred shares have terms favourable to the issuer and are overly complicated for retail investors. Better to stick with plain vanilla issuers with simple preferred share structures. Many preferred share issuers have been issuing similar classes of preferred shares for decades (sometimes generations). These series of preferred shares “occasionally” get redeemed when interest rates fall a lot but are then issued again with new “coupon” (i.e. dividend) rates.

Investment Advice

If you have an interest in preferred shares, the best place to go is your investment advisor. Larger brokerages have in-house lists of preferred shares suitable for your objectives.