Preferred Shares: An Income Investment you may have overlooked
Investors seeking income often limit their selection to bonds and give little or no consideration to preferred shares. They usually ignore preferreds simply because they don’t know much about them.
Perhaps the easiest way to think of preferred shares is that they are shares which behave like a bond. A preferred share represents an ownership interest in a corporation, just as common stock does. But it also produces a reliable stream of income — in the form of a pre-set dividend — very much like the interest paid on a bond. The price of a preferred moves with interest rates, like a bond’s price. When interest rates rise, the price of the preferred 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., rate many preferred issues — from highest quality (P-1 or PFD-1) to speculative (P-5 or PFD-5). And, like bonds, most preferred shares can be “called,” or retired, by the issuer. In most cases, the call price is above the par value (price at which shares are originally issued).
Preferreds are well-suited to relatively conservative investors. They are also useful for more aggressive investors who want to balance a portfolio heavily weighted towards growth stocks. The income from preferreds can boost the current yield on shares of companies that usually reinvest their earnings in their fast-growing businesses rather than pay dividends.
Preferred shares offer the following attractions:
• High Yield Preferred shares typically yield one to three percentage points more in dividends than common stock issued by the same company. Since dividends are paid quarterly, many investors purchase three or more preferred issues with different payment dates to assure themselves a monthly dividend cheque.
• Liquidity Many preferred issues are listed on the major stock exchanges, making them easy to buy and sell. Most preferred shares are issued at par values of $25, putting them well within the reach of individual investors. Older issues trade above or below their par value depending on interest rates and other market conditions.
• Safety Preferred shares rank senior to common shares — that is, preferred shareholders’ claims for dividends and corporate assets (in the event the company is liquidated) come before common shareholders’ claims. If a company runs into serious financial problems, the board of directors may vote to reduce or skip the preferred dividend without placing the company in default. But most preferred stock is “cumulative,” so missed dividends accumulate and must be paid to preferred shareholders before any dividends are paid to common shareholders. (Keep in mind, though, that preferred stock is junior to all the company’s debt. Bond interest payments take priority over preferred dividends and bondholders would get paid off first if the company were dissolved.)
The dividend on some preferred issues can be increased by the board if the company does especially well and the common stock dividend rises to a certain level. Such issues are called “participating” preferreds and usually command a premium price. Most preferreds are “non-participating”; their dividends never change, regardless of how high the common stock dividends rise.
Retractable preferreds have a fixed term which means the investor has the right to sell the shares back to the issuing corporation at a certain price on predetermined dates. The investor is, therefore, guaranteed a selling price. These shares are most attractive to investors who require a steady income and are concerned about the preservation of capital.
Convertible preferred shares offer income-oriented investors a chance at capital appreciation, too. These are preferred shares that can be exchanged for a specified number of common shares. The trade-off is that prices of convertible preferreds typically fluctuate more than those of non-convertible issues. They are probably not for investors who value a relatively stable share price.
One major advantage of investing in preferred shares is the dividend tax credit which eases the tax burden on dividend income. Essentially, all dividends collected on Canadian companies are eligible for this tax credit.
With this in mind, quite often preferred issues are an excellent alternative for producing income as compared to other interest-bearing investments which are fully taxed.
For a complimentary guide to Preferred Shares Click Here
This publication has been prepared by ScotiaMcLeod, a division of Scotia Capital Inc.(SCI), a member of CIPF. This publication is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication. This publication and all the information, opinions and conclusions contained in it are protected by copyright. This report may not be reproduced in whole or in part, or referred to in any manner whatsoever, nor may the information, opinions, and conclusions contained in it be referred to without in each case the prior express consent of SCI. Scotiabank Group refers to The Bank of Nova Scotia and its domestic subsidiaries.
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Comment by Joseph on 11 June 2009:
Hi.
How are you? I have a question that you likely may have asked thousands times.
Anyway, here it is.
I notice that a lot of preferred share issued in the past has gone under its face value - e.g. RY.PR.G is currently trading around $18.xx dollars. The yield is ~6%. However, when RY redeems the share, RY will pay $25; this is an additional 30% gain (note that I never see preferred share issues in the 90s still running around so within 10 years, the share will be redeemed).
Question is it looks like a very good deal to me but why people are still buying the new preferred share instead?
Do I miss something?
Thanks.
Comment by Christian Farstad on 12 June 2009:
Joseph
Thanks for the note. I am doing great!. Your question is a good one and it is very common. Preferred shares are quite complicated as there are actually many different types. The Royal Bank Preferred series G that you mention is a straight perpetual preferred share issued at 4.50%. This type of preferred share has no maturity date. It pays the dividend as long as it remains outstanding. However, the issuer has the option of redeeming these while the holder has no retraction rights at all. As a holder your choices are only to hold indefinitely or sell on the secondary market.
Most of the new issues of Preferred Shares that are coming out are called Rate Rest Preferred shares. For example, a recent new issue was Royal Bank 5-year Rate reset series X at a 6.1% dividend rate. The rate resets pay a fixed dividend until the reset date, which is typically also the call date. On that date, and every reset date thereafter, if the preferred share is not called, the holder has 2 options.
1. Locking in a fixed dividend rate until the next reset date. This is at a predetermined spread over an equivalent term Government of Canada bond.
2. Exhange to a floating rate preferred share. The floating rate is a quarterly dividend based on 3-month Government of Canada T-bills, plus the same spread as in option 1.
Investors have the option at each reset date, if the issue is not called, of switching back and forth between the two dividend options. These are redeemable at the option of the issuer at each reset date. Rate resets are perpetual in nature and are not retractable by the holder.
Advantages of the newer rate resets over the perpetual preferreds?
Investors in rate resets get an attractive dividend rate which is re-set in-line with yields prevailing in the market on a periodic basis. Due to this factor, these have less interest rate risk than straight perpetual preferred shares. So in other words, if interest rates rise than RY.PR.G will lose more value than RY.PR.X.
People also like the rate resets recently because of the higher dividend payout rate. The RY.PR.X pays 6.1% whereas the the RY.PR.G pays only 4.5%. For investors with non-registered accounts this increased payout allows better after-tax income when they are able to use the dividend tax credit.
There are couple of other reasons that people are choosing rate resets recently but these are the main reason. I have a great guide to preferred shares I can send you if you have interest. It has detailed descriptions of the different types of preferred sahres and it gives recommended buys for each type. Send me an email at christian_farstad@scotiamcleod.com if you would like a copy. I can also put you on my list of people to call with new issue information when preferred shares come out. Let me know.
I hope this helps,
Christian Farstad, CFA, CFP, FCSI
Comment by Jean-Noel on 17 July 2009:
Hello Christian,
I read your comments issued on ProfessionalReferrals.ca on Preferred Shares with interest and found them very useful.
As an individual I have a good general financial background but it is just enough to make me realize how complex making decision on preferred shares is.
I have a question regarding BCE preferred and more specifically on the Cumulative Redeemable First Preferred Shares, Series AA. I read the prospectus but am not entirely sure what is the formula to set the dividend rate in the future. Could you you put it in laymen terms for me?
You also mentionned a guide you have on preferred shares. Is it still available?
Many Thanks for your attention!
Best! Jean
Comment by Christian Farstad on 21 July 2009:
Jean,
Thanks for your comments. I do appreciate them.
I do still have the guide for preferred shares and I will forward a copy to your email address.
To answer your question, the dividend rate for the BCE series AA preferred shares is set at 4.8% until Sept 1, 2012. The rate is fixed until that date. After that date the company will offer 2 options to the holders. The first option is to continue with a fixed rate and that rate is set at the discretion of the company - within limitations. The rate will normally be 80% of the yield of Canada 5 year bonds. That is the rate that has been offered by similar structured preferred shares and we assume that is rate BCE will offer.
The second option is to take a floating rate. The dividend will be paid monthly. The rate will be anywhere from 80% of prime to 100% of prime. This rate is dependent upon the the price the preferred share is trading at on the open market. If the share price is trading at under $24 than the rate will be 100% of prime. This is what most floating rate shares are paying now as they all trade below $24.
This preferred share issue wouldn’t be my first pick in this environment.
I hope this gives you this information you require. I continue to recommend to investors to get good advice when making preferred share purchases. The cost of good advice will pay for itself if it prevents you from making even one little mistake in the preferred share realm.
All the best
Christian Farstad
Comment by a.somani on 11 September 2009:
Dear Mr.Farstad,
Iam a retiree W/very limited knowledge about investment or capital;with my around 60k-until now i gotsome income from GIC that helped pay for monthly groceries.My friend suggested i should look into buying perpatul preferred shares that would provide income and in distant future give capital gain also.From his old list of June 09, I leart that in this 2 to 3 months price has shot up by atleast $3 to$4 of banks and ins,co,except for some lower co. has gone up a little.
I cant afford financil planner,all i need is your expert advice weather this would be right time to buy and if so then can you send me latest list of perpatul shares.Your comments would greatly appriciated.Ihope to invest 60k to earn approx. $800 To S1000 quarterly.
Thanking you in anticipation ,
somani.
Comment by Christian Farstad on 17 September 2009:
Dear Somani:
Please do not invest your nest egg in perpetual preferred shares shares. They are quite high risk and you could have significant price fluctuations on the preferred shares. If your only experience in investing is GICs perpetual preferred shares are not a good next step investment.
Please send me a note directly to christian_farstad@scotiamcleod.com so we can discuss in more detail.
All the best
Christian Farstad
Comment by Gail on 7 January 2010:
Hi,
I’m going to be investing in a TFSA for 2010. In 2009 I bought RBC preferred shares for my TSFA. Should I buy more RBC preferred shares (RY.X) or should I purchase something else? If something different is recommended, what might that be? By the way the statements from RBC Direct Investing show that the 2009 preferred shares (RY.PR.R) purchase is doing very well.
Do you know anything about management fees (MER’s)and transactions fees regaring the RBC preferred shares for a TFSA? I am reinvesting my dividends and wonder if I’m paying a fee for these transaction. I don’t want my yields to be eaten up by transaction fees.
Thanks.
Comment by Christian Farstad on 11 January 2010:
Gail
Preferred shares have been great investments over the past year. The specific issue RY.X was issued in the summer at $25 paying 6.1% interest. It now trades at $28.05. This is a great gain.
RY.X is a rate reset preferred share. The current yield on the issue is 5.44% but you have to remember that it has a reset date Nov 24, 2014 where the company can end the issue by giving you back $25.00. If you purchase at $28.05 you will get a capital loss. This needs to be calculated into the rate of return. We call this the yield to call and for ry.x it is only 3.55%.
The great thing about preferred shares is that the dividends they pay receive preferential tax treatment but only if invested in a non-registered account. TSFAs, RRSPs, RRIFs and other tax sheltered accounts do not allow you to access this preferential tax treatment. I don’t generally recommend preferred shares for tax sheltered accounts because you lose out on the preferential tax treatment.
There aren’t any management fees for holding preferred shares with a discount brokerage normally but you do have to pay a commission to purchase and sell the shares. You are reinvesting the dividends not into more of the preferred shares instead you are buying common shares of Royal Bank. There are no costs that I know about and, in fact, you are purchasing the common shares at a 3% discount.
Not knowing your situation makes it impossible to make a personal recommendation. If you contact me directly we could discuss in more detail your situation and then I would be able to make a personal recommendation.
As a general recommendation only, I would prefer the common stock over the preferred shares in Tax Free Savings Account so that you can get some long term growth while receiving a nice dividend payment along the way.
All the best,
Christian Farstad, CFA, CFP, FCSI
My preferred share guide to investing
Comment by Nelson Dias on 10 February 2010:
I have a TFSA and was hoping to use dividend paying stocks in it for a quarterly income. I have approximately 50K to invest.
Do you have any comments on my proposed investment strategy.
Thanks,
Nelson
Comment by Christian Farstad on 2 March 2010:
Nelson
You mention that you have a TSFA (tax free savings account) and that you have $50,000 to invest. You can only contribute $10,000 to the TSFA so far. That leaves $40,000 outside your TSFA.
Your investment strategy is to use dividend paying stocks. Not knowing your personal situation I can not give direct advice. In general though I do like the dividend paying stocks. Remember that Canadian dividend paying stocks give you a tax credit in Canada when held in a taxable account. If you have a balanced type account and you are also holding some bonds or GICs with income that is not tax advantaged, you may want to hold those investments inside your TFSA and leave the dividend paying stocks outside to the TSFA to get the tax advantage.
Good luck!
Christian Farstad
Comment by Christian Farstad on 8 March 2010:
Dear D. Rosenberg:
My advice depends on how much you are withdrawing from savings each year. Also, ensure that when you are withdrawing from RRSPs that you convert a small portion of your RRSP to RRIF so that you can get the $2000 pension income tax break.
Right now you are sitting with lots of cash. Is that on purpose? Feel free to contact me directly to discuss further at christian_farstad@scotiamcleod.com
Regards
Christian Farstad