Preferred Shares – Is this the new replacement for fixed income?
As readers of my blog you’re probably well aware that common stocks that pay dividends and low-cost, diversified Exchange Traded Funds (ETFs) – are the two primary building blocks of my investment portfolio.
But what about preferred shares? Why not own them? What are they in the first place? Should you consider owning them in this rate environment? If so why or why not?
I’ve been thinking about writing a comprehensive post about preferred shares for some time. Thanks to a recent reader request here is it today. First though, I want to introduce the reader himself who authored most of this post with me – Matthew Wilson.
Matthew Wilson is an entrepreneur, investor, and co-founder of Calgary Beer Week. Having started his first company at age 11, he now works as an advisor to start-ups and early stage organizations, helping to build their business model, sales, and marketing strategies. He currently writes at GRGcollective.com about personal finance, entrepreneurialism, and personal development.
(Editor’s note: who doesn’t love craft beer?)
Matthew’s bio goes on to say he started his first company at age 11 and sold his last one at age 28. Now in his mid-30s he continues to love all things money and wanted to write this post – a point counter-point article about preferred shares with yours truly.
Preferred Shares 101
Matthew, this is how I describe preferred shares: it’s a hybrid between a bond and a stock. With “preferreds” you get the elements of a bond (through fixed income) but you also get some upside with capital gains. Thoughts?
Mark, I like that. We’re all familiar with the term common stock (or common shares). The TSX is full of familiar ticker symbols, like RY (Royal Bank), MFC (Manulife Financial), and ENB (Enbridge), to name a few. But when you search “RY”, for example, have you ever noticed this list?
This multitude of “RY.PR” symbols refer to various series of preferred shares.
I like this definition of preferred shares: consider it like VIP shares in a company:
- As an owner, you get the first crack at any dividends issued by the company ahead of any common shareholders.
- In addition, when a preferred share is first issued, the dividend yield is both fixed and at a higher rate than the yield for common shares. For example, the common share RY (Royal Bank) is currently yielding around 4%, whereas the preferred share PR.I has a fixed cash dividend of 5%.
- Lastly, should a company become insolvent, preferred shareholders get paid ahead of common shareholders upon the liquidation of assets.
Fair points Matthew – but I like my income and capital gains from my common stocks. I don’t think preferreds have as much upside as common stocks do long term. I also believe companies that increase their common stock dividends can be far better long term investments. Preferreds offer no such ability.
What’s your take? Why should I consider preferred shares for my portfolio?
Mark, given your existing holdings with what, 30+ Canadian dividend paying stocks (?) – this is a great question. Actually, it’s a great question for many folks to ask, particularly Boomers since their search for yield has never been more prevalent.
Before I answer your question – let’s go back to the difference between preferred shares and common stock. Since preferred shares offer a fixed dividend rate they are classified as a fixed income security, and as such, belong to the fixed income portion of your portfolio.
Second, it’s important to note a recent key shift in the structure of the preferred share market.
Prior to the credit crisis of 2008, the majority of preferred shares in Canada were known as perpetual, meaning they had no fixed maturity date and could be called back by the issuer, for par value, at any time in exchange for cash. The high yields protected perpetuals from downside risk, whereas the possibility of getting bought back by the issuer at par value hindered the potential for any upside capital gains. Thus, to your earlier point about limited capital upside, price movements among perpetuals were typically quite minimal, with values remaining close to their initial issue price.
During the credit crisis, however, confidence in the financial sector plunged, and investors were no longer sure if the issuers of these perpetuals would ever be able to buy them back at par value. As a result, the value of perpetuals plunged.
Following the credit crisis interest rates hit all-time lows, and with the only direction to go being up, investors wanted a product that would protect them from rising interest rates. As such, the rate-reset preferred share was created.
In short, the rate-reset can still be bought back by the issuer, but investors now have the option to “reset” their dividend yield every 5 years at a rate equal to the Bank of Canada’s 5-year bond, plus a premium. For example, if in 5 years the Bank of Canada 5-year bond yield is up to 3%, and the preferred share issuer offers a 3% premium, investors will have the opportunity to reset their dividend to 6%. (Note: the value of the premium and time horizon until being eligible for a reset varies depending on the issuer, however, it’s typically every 5 years).
With this new-found protection against rising interest rates, the popularity of rate-resets surged, and the majority of the Canadian preferred share market quickly shifted to the rate-reset format.
However, since the Bank of Canada unexpectedly cut interest rates twice in 2015, rate-reset preferreds got dramatically oversold and their market value got hammered, dropping approximately 33%. Investors who foresaw the eventual rebound of interest rates were able to lock-in dividend yields north of 7% while they waited for market values to return.
Since rates bottomed out in early 2016, and with the Bank of Canada now on pace to raise interest rates for a third time this year (time will tell…) rate-reset preferreds have been one of the best performing asset classes on the market, up approximately 28% from their bottom in early 2016, all-the-while paying an attractive 5%+ dividend.
So, to answer your original question, should you consider them for your portfolio? I think you should since you can earn an attractive yield while capitalizing on an oversold asset class that will produce capital gains in a rising interest rate environment.
Alright Matthew, a compelling case, but what are the upsides and downsides of owning preferred shares? With common stocks shareholders don’t have to worry about interest rates as much due to the lack of fixed income component. Often the elderly, buy preferred shares for “safety” only to see their investments decline significantly in value when interest rates change. People somehow equate preferreds with the bond component as safe. That’s hardly true.
Mark, you’ve raised a very important point. As we can see from the chart above, owning preferred shares in a declining interest rate environment is not conducive for capital gains. However, we know interest rates will not stay at zero forever. So, as interest rates (slowly) continue to rebound we will experience additional capital appreciation among rate-reset preferred shares.
So if I was to hold preferreds, at all, I would consider owning them in registered accounts first, to maximize those accounts before non-registered. What’s your take?
That’s always a good plan – to maximize contributions to your registered accounts first (e.g., RRSP, TFSA, RESP for kids) before investing in a non-registered account. But it’s worth mentioning for readers unlike bonds, where interest is taxed at your full marginal tax rate, the dividend income from preferred shares qualifies for the Canadian Dividend Tax Credit. I know that’s something you highlighted here.
So, if your registered accounts are already maxed out, preferreds can have a non-registered home.
Matthew, given the structure of “preferreds”, I really don’t see a compelling reason to own them right now. I mean, I think it will be decades if/when bond yields are modest. So why the rush to own them if the capital upside won’t be there?
Your concerns regarding the outlook for bond yields are quite valid Mark. Ultimately, like any type of investment, the decision to own preferred shares will depend on your personal feelings, views on where the market is headed and of course what your financial plan says you should do.
Back to what I wrote about above, you now know owning old-style perpetual preferred shares is certainly not a great option. However, given the unique structure of rate-resets, these type of preferreds are poised to largely benefit in a rising interest rate environment.
o, my question back to you is: where do you foresee interest rates going?
Matthew, I really have no idea. They could go up, down, stay flat, rise a bit, then fall, spike only to dip again. Like the weather tomorrow, I really have no idea. So, I don’t speculate on that stuff and I don’t invest in them for this interest rate risk. If I had to guess, rates will probably go up over time but it’s going to be a very long road (as in decades) largely due to demographic reasons.
Mark, I’ll offer my take. Looking back, historically the Bank of Canada will typically raise multiple times in a continuous cycle over the course of several years. If we look at the last 4 rate-tightening cycles here’s how the data plays out:
- 1999–2000: 4 rate hikes over 2 years.
- 2002–2003: 5 rate hikes over 2 years.
- 2004–2007: 10 rate hikes over 4 years.
- 2010: 3 rate hikes in 1 year.
From this data, we can reasonably expect to see approximately 3 to 6 increases over a short period of time. Will it happen? Will we ever get back to the days of 16% interest rates? I highly doubt it as well but I suspect it will go up again over time.
BoC Benchmark Overnight Rate – Since 1991
Looking at the long-term trend, interest rates have bottomed-out. Things seem to be on the rebound. As long as the Canadian economy continues to outperform, and job growth stays strong, I don’t foresee the Bank of Canada having any reason to abort its tightening cycle anytime soon.
We’ll see though Mark. After two rate increases already this year, what happens with the next decision will come as soon as October 25th.
BoC Interest Rate Decision Calendar – 2017
In any event, to your interest rate risk, as long as interest rates aren’t trending downwards I believe there is merit in holding preferred shares. For sure, you may not realize much in terms of capital gains when compared to common stocks, but you’ll collect a nice dividend, which is more than double the yield on any current bond or GIC. It’s important to highlight preferreds are not bonds though.
Absolutely not. OK, let’s wrap up this essay on preferred shares Matthew. Do you personally own preferreds and if so, which ones? (Disclosure – I don’t own any.)
Yes, I do own preferred shares as they make up approximately 45% of the fixed income portion of my portfolio. Earlier I showed you there are almost endless options when buying preferred shares. For this reason, I strive for simplicity and have opted for some of the various preferred share ETFs available on the Canadian market. The three that I own are:
- Invests in Canadian preferred shares
- Symbol: CPD
- Current yield: 5%
- Distribution frequency: Monthly
- Geographical weighting: 100% Canadian.
- Invests in a diversified basket of U.S. and Canadian preferred shares
- Symbol: XPF
- Current yield:6%
- Distribution frequency: Monthly
- Geographical weighting: 50% Canadian, 40% U.S., 10% Global.
- Invests in a diversified basket of rate-reset Canadian preferred shares
- Symbol: ZPR
- Current yield: 6%
- Distribution frequency: Monthly
- Geographical weighting: 100% Canadian.
I own CPD for exposure to the Canadian preferred share market. I also like XPF because it largely benefits from rising interest rates in the U.S and is hedged to Canadian dollars, therefore no need to worry about currency exchanges. ZPR is the newest of the three ETF products, and I purchased it as an experiment to see how it would perform in relation to the others. To my surprise, it has been my top performer.
Matthew, I want to thank you for this detailed look at preferreds based on your perspectives – and inspiration to get this subject covered on my site.
For the time being, I’m going to stick with my common stocks and some low-cost ETFs for my portfolio. I believe things remain more simplified within my investment portfolio this way. Besides, I’m in my asset accumulation years. In these years, I’m counting on dividend income, and dividend increases, I’m also counting on capital gains as much as possible as well. I suspect for retirees or folks depending on some fixed income, preferreds can offer some steady income and deliver lower volatility than common stocks – certainly a consideration for some income investors depending upon the construct of their financial plan including their risk tolerance.
Thanks for doing this comprehensive post with me and I look forward to chatting about more personal finance and investing topics with you in the future.
What’s your take on preferred shares? Do you own them? Why or why not?