Preferred Shares Explained
Dwight Mann - Apr 17, 2019
As interest rates have continued to fall over recent years, investors have been forced to take on more risk in the equity markets in search of higher yielding investments. Investors have looked towards banks, telecoms, and pipelines to fulfill this need for dividend yield. The problem with forcing more money into the equity market searching for a higher return, is that many risk averse investors have taken on unnecessary risk. Preferred shares offer investors an opportunity to reduce their market exposure and still be able to meet their investment objectives.
Preferred shares pay a set return that is fixed as a percentage of its par value ($25), like a bond. However, unlike bonds or GICs this return comes in the form of a dividend. GICs and bonds generate interest income, which is taxed at the highest marginal tax rate. Preferred shares produce dividends that are taxed favourably, as dividend income is eligible for the dividend tax credit when held outside of a tax-sheltered account.
Over the past several years perpetual preferred shares have experienced very little volatility. However, in the last couple of months the average perpetual preferred share price is down 10-15% as a result of market nervousness regarding the interest rate cycle. The price of preferred shares usually moves with interest rates (when rates rise, prices fall) but over this period of time, rates have actually fallen. Most of the sell-off is tied to investors exiting the market following the substantial losses incurred in the rate-reset market. Investors have been indiscriminately selling off all preferred shares, regardless of the type (i.e. rate resetting preferred shares). This discrepancy presents an opportunity. Many preferred shares offered by large Canadian blue chip companies are trading in the low $20s and are yielding 5.8% (i.e. George Weston, Sunlife, Power Corp).
There is a great disconnect between the bond market and the preferred share market. This disconnect is providing us with an opportunity to take advantage of the great value in these tax friendly investments. For example, if we were to buy a 30yr Fortis bond we would be looking at a yield of around 4.5%. On the other hand, if instead of buying the bond we invested in a Fortis perpetual preferred share we would be looking at 5.75% yield plus a dividend tax credit. The yield on a preferred share, on an aftertax basis, works out be a 7.5% interest rate equivalent. We feel that this is the best opportunity in perpetual preferred shares in the last 5 years.
Just to be clear, we are strictly talking about perpetual preferred shares. The rate resetting preferred shares that we’ve warned about in previous letters may still see some further volatility towards the end of the year. As year-end approaches these preferred shares could come under further selling pressure from tax loss selling in December.
Not only do we feel that this is a great opportunity to capture an attractive yield in this low interest rate environment, but also we feel that the market has these investments mispriced. Thus, there is room for some capital appreciation as these investments move back towards their issue price. This dividend income can provide a steady source of income for retirees, or a conservative options for risk adverse investors that want an attractive yield without the equity market risk. Preferred shares might not be appropriate for all investors so we suggest you seek advice in determining if these investments are suitable for you. If you would like to discuss some of these points in more detail, don’t hesitate to