In this article we continue an overview of different types of securities. In previous articles we presented government, corporate investment-grade and corporate speculative-grade bonds. Here, we present a hybrid investment instrument, preferred shares, or preferreds for short, which combines features of both bonds and stocks.
Most preferred shares have a fixed dividend payment which makes them similar to bonds and attractive for investors. The dividend is specified as a percentage of the par value, where the par value is usually the price at which the preferred share is issued at. Sometimes, dividends on preferred shares are of a floating type and change with changing benchmark interest rates.
Preferreds have priority over common stock in the payment of dividends: the company must pay the dividends on a preferred stock before paying any dividends on common stock, although this priority does not assure the payment of any dividends. In terms of dividends, preferreds can be cumulative or noncumulative. Cumulative preferreds accumulate dividends that the company failed to pay before the stated date. Noncumulative, or straight, preferred shares lose any dividends which have not been received within the designated payment period.
Sometimes companies defer payment of dividends which bear fewer consequences for their credit ratings as compared to a failure to pay a bond coupon which leads to a default. This is why preferred shares are considered higher risk to the investor than bonds.
In terms of rights to their share of the company’s assets, preferred shares rank below bonds but more senior to common shares. Other features of preferreds that may be available in certain instances include convertibility into common stock and callability. The latter means that the company issuing the preferred share, at its discretion, may redeem or prematurely buy back the preferred share issue. Some preferred shares have special voting rights to approve extraordinary events (such as new share issues or approval of mergers and acquisitions) or to elect directors, but most preferreds do not participate in voting.
In Canada, preferreds occupy a significant share of capital markets. One of the reasons for the popularity of preferreds in Canada is preferential tax treatment of dividend income as compared to interest income. Because of this, some Canadian investors, who invest in fixed-income securities, choose preferreds.
In 2013, the Canadian preferred shares market had some tough times and posted its first negative returns after several positive years (see the table). For 2013, the S&P/TSX Preferred Shares Index had a total return of -2.6%, as compared to a 13.0% total return for the S&P/TSX Composite index. The decline in preferred stocks started in the middle of the year with the onset of expectations that the US Federal Reserve would start tapering its Quantitative Easing program. This brought down the prices of fixed income instruments including preferred shares. If the current low interest rate environment continues, this may reduce yields and correspondingly raise prices of preferred shares.
Investing in preferred shares takes time and skill. According to investment bank Raymond James, in 2014, many of the preferred shares issued by top-quality banks and insurance companies may be redeemed. Those are so-called fixed-resets or preferred shares that have a dividend rate reset every five years, when the shares can also be redeemed at the issuer’s discretion. The investment bank suggests that investors beware of preferred shares index funds (ETFs) this year because ETFs may start acquiring riskier preferreds due to the limited supply of higher quality preferreds.
Michael Zienchuk, MBA, CIM
Investment Advisor, Credential Securities Inc.
Manager, Wealth Strategies Group
Ukrainian Credit Union
Mutual funds and other securities are offered through Credential Securities Inc. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise stated, mutual funds and other securities are not insured nor guaranteed, their values change frequently, and past performance may not be repeated. The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This article is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell any mutual funds and other securities. The views expressed are those of the author and not necessarily those of Credential Securities Inc.®. Credential is a registered mark owned by Credential Financial Inc. and is used under licence. Credential Securities Inc. is a Member of the Canadian Investor Protection Fund.