The main reason to invest in preferred shares is for investment income. With the recent changes announced by the federal government, dividend income from Canadian public companies will now be taxed more favorably. The increase in the dividend tax credit eases the tax burden for most individuals generating dividend income within non-registered accounts. Preferred shares are an excellent alternative for producing tax efficient income when compared to interest-bearing investments, such as bonds and GICs which are fully taxed.
One way to understand preferred shares is to combine the features of both common shares and bonds. Preferred shares are similar to common shares in that they are both equity investments and represent an ownership interest in a corporation; however, preferred shares behave more like a bond. The following are the main similarities between preferred shares and bonds:
- Preferred shares produce a reliable stream of dividend income very much like the interest paid on a bond.
- Preferred shares are interest rate sensitive similar to bonds – when interest rates rise, the price of preferred shares generally falls, and when rates fall, the price rises.
- The same independent services that rate bonds, namely, Canadian Bond Rating Service Inc. and Dominion Bond Rating Service Inc., also rate many preferred issues.
- Like many bonds, most preferred shares can be “called” or “retired” by the issuing company.
- Both bonds and preferred shares may be purchased in other currencies.
The similarities between preferred shares and bonds help to illustrate how preferred shares may be suitable for conservative investors wishing to include lower risk equities in their portfolio. For investors heavily weighted in income trusts the addition of preferred shares can help to achieve greater diversification.
Preferred shares offer the following advantages:
- They typically yield one to three per cent higher than most dividends from common stock issued by the same company.
- Dividends are paid quarterly but each company may pay on a different month. With a little planning many investors purchasing three or more preferred shares may be able to structure a consistent tax-efficient monthly income.
- Most preferred shares are listed on the Toronto Stock Exchange, making them easy to buy and sell. New preferred shares are issued at par values (generally $25), making them affordable for many individual investors.
- They rank senior to common shares in the event that the issuing company becomes insolvent or is liquidated. If a company runs into financial problems, the board of directors may vote to reduce or skip the preferred dividend without placing the company in default. Fortunately most preferred shares are “cumulative,” so missed dividends accumulate and must be paid to preferred shareholders before any dividends are paid to common shareholders.
- Dividends on some preferred shares may be increased by the board if the company does especially well. This feature is generally referred to as “participating” preferred shares. Most preferred shares are “non-participating” where the dividends never change, regardless of how well the common shares perform.
Not All Preferred Shares are Created Equal: As capital markets expand and become more complex so have the characteristics of preferred shares. Prior to investing in preferred shares it is important to understand the different types, features, and the associated risks of each.
Hard Retractable: Hard retractable preferred shares have a fixed maturity date usually between five and ten years from the date of being issued. They have a feature that allows the shareholder (investor) to force the company (issuer) to redeem the shares at par value for cash on a specified date. This type of preferred share most closely resembles bonds. As noted above, the value of preferred shares will vary with changes in interest rates. Hard retractables are generally less sensitive to interest rate fluctuations because of their fixed maturity date.
Soft Retractable: There are a large variety of issuers of soft retractable preferred shares with different yields, credit qualities and maturities. Soft retractable preferred shares are term preferred shares that give the company (issuer) the option of repaying the par value in cash or in common shares. Shareholders (investors) can force redemption by the company, but the consideration offered can vary. As a result the investors’ retraction feature is considered “soft” (for cash or shares) as opposed to “hard” (for cash). This payment option gives the company greater flexibility because they can pay the preferred retraction in shares instead of cash if it is advantageous for them to do so.
Unlike hard or soft retractables, perpetual preferred shares have no fixed maturity date. They pay a straight dividend for as long as they remain outstanding. The shares may be redeemed at the option of the company but the holder has no retraction rights. If a perpetual preferred is not redeemed by the issuer, investors have the option of selling them in the secondary market or holding them indefinitely. The risk in holding this type of preferred share is that they are very sensitive to fluctuations in interest rates because they are comparable to long bonds in the way they trade. Compared to all other classes of preferred shares of similar credit rating, perpetuals are riskier. Perpetuals may complement a balanced portfolio strategy and a diversified portfolio of preferred shares.
Floating and Split are two additional types of preferred shares with their own unique features. Before investing in preferred shares it would be prudent to understand their various attributes along with the opinion of the debt rating agencies while keeping an eye on interest rates. Some investors may benefit from using a basket approach with different types.
Before implementing any investment ideas or strategies discussed in our columns we recommend that you speak with your financial and tax advisors to discuss your specific situation.