Preferred shares are securities that generate fixed income at attractive, tax-friendly rates, which can be shaped to take advantage of the interest-rate environment.
How do preferred shares work? And how can you use them in your portfolio? Here are some of the advantages and disadvantages to this asset class.
What Are Preferred Shares?
Preferred shares are hybrid fixed-income securities. They are on the equity side of the issuers’ balance sheet and generate a fixed dividend rather than interest income. The dividend is set in the issue prospectus and can be considered fixed income. Although historically considered a very conservative investment, investors shunned this asset class for a few years, from January 2015 to the end of 2020.
This period of waning demand for preferred shares resulted in very attractive dividend yields but also temporary illiquidity and price volatility.
How Do Preferred Shares Work?
Some companies, such as oil pipelines, banks or utilities, require a high level of debt to operate. Preferred shares can also have tremendous advantages for these companies. They provide access to more flexible financing than debt and a much lower cost of capital than common stock. This optimizes the amount of debt and equity for the company and makes the cost of capital more efficient.
Most preferred shares are issued at $25. Dividends are always calculated on the issue price, even if the market value changes all the time. Therefore, a preferred share with a 5% dividend rate will pay an annual dividend of (5% x $25) $1.25. The dividend is usually paid quarterly, i.e., one quarter of the annual amount, 4 times a year. Since they are traded on the stock market and their prices fluctuate, we could buy the preferred share in the recent example, which pays a dividend of $1.25, at a premium (over $25) or at a discount (under $25). We would then have a current yield rate better or worse than the 5% posted depending on our purchase price. For example, if we buy this stock at $20, our current yield will be $1.25 on a cost of $20, i.e., 7% instead of the 5% that is posted in the prospectus and based on the issue price of $25.
Preferred Shares vs Bonds
Preferred shares sit on the equity side of a company’s balance sheet. Unlike bonds and debentures, it is not a debt owed to the investor by the issuer. In other words, when you buy a preferred share, no one owes you money. It is a security that is part of the capital stock of companies.
This fact leads to some important differences between preferred shares and bonds. First, there is no maturity. Bonds have maturity dates at which the company must return the money loaned to you and complete the loan agreement. Instead, preferred stock has redemption dates where the issuer has the right (but not the obligation) to redeem the securities at a predetermined price or roll them over for another period. Second, preferred shares pay a fixed dividend that is paid from the company’s after-tax income and taxed at a favorable rate to the shareholder. From a taxation perspective, this is advantageous compared to interest income, which is paid out of the company’s pre-tax income and taxed to the beneficiary (or the preferred shareholder) at their marginal rate. Third, it is usual for preferred shares to have rate adjustment clauses given the absence of a firm redemption (repurchase) date.
LRNs and Preferred Shares
The arrival of limited recourse capital notes (LRNs) in Canada in July 2020 has been a huge game changer for this market, which had been neglected by investors in recent years.
LRNs provide companies with a financing option that is different from preferred shares and attractive to issuers, as they allow them to deduct interest while providing access to similar capital in the form of preferred shares. As a result, we expect that a good portion of the outstanding preferred shares will be redeemed and that there will be an imbalance between the investment products available and the demand for this asset class which will support strong performance in this sector.
Types of Preferred Shares: Floating, Perpetual and Rate Reset
There are several types of preferred shares, but the main ones are floating rate preferred shares, perpetual preferred shares, and rate reset preferred shares.
Floating rate preferred shares are securities that pay a dividend that is adjusted every 3 months. They are usually based on short-term rates such as treasury bills or bank prime rate, as well as a percentage for the risk premium, to which you add the predetermined risk premium for total dividend payout.
Perpetual preferred shares pay the same amount of dividend in perpetuity or until the company redeems its stock. This class of preferred stock was very popular when rates were higher. However, when interest rates started to fall, investors became wary of investing at low rates for an indefinite period of time!.On top of that, the issuer usually has a call feature which allows them to redeem the shares if they wish, which may be undesirable for the investor.
Rate reset preferred shares. With lower rates, investors have been asking for a mechanism for adjustments, so they don’t get stuck with an anemic dividend if rates go up. Reset preferred shares have this feature, but are a bit more complicated. They have a clause that implies a rate adjustment every 5 years, as well as the possibility to choose between a fixed or variable rate. They are issued with a dividend that is built in two steps. First, the initial rate is fixed for the first 5 years. The rate base consists of a risk premium that will be fixed indefinitely. Second, in addition, the investor can choose between a fixed rate or a floating one. If they choose a fixed rate, they will receive the benchmark 5-year Government of Canada bond rate. If they choose a floating rate, they will receive 3-month treasury bills. Here is what happens every 5 years:
Issuer’s two options:
- Renew the security for an additional 5 years OR
- Buy-back the security at the original price ($25)
Investor’s options, if the issuer chooses to let the security run:
- Choose a fixed rate consisting of the addition of the risk premium set out in the prospectus and the Canada 5-year bond rate in effect on the five-year anniversary date of the security for the next period OR
- Choose a floating rate composed of the addition of the risk premium and the 3-month treasury bills that will be adjusted every quarter for the next 5 years.
Here’s an example. The company issues at time zero, a preferred share with a risk premium of 2.5% while the 5-year benchmark rate in Canada is 2.00%. The reset preferred share will have an initial dividend of 4.5%, i.e. ($25 * 4.5%) $1.125. On the 5th anniversary of the issue, if the 5-year rate in Canada is 3% and the investor chooses the fixed rate, the new rate for the next 5 years will be 3% plus the risk premium of 2.5%, therefore 5.5%. On the 10th anniversary, if the rates are 1%, the new fixed rate will be (1% – Canadian 5-year rates + 2.5% – risk premium) 3.5%, etc.
Reset preferred shares have been very popular over the last two decades, as investors anticipated a recovery in interest rates. In fact, they represent nearly 80% of the S&P/TSX Canadian preferred share index. However, although favoured by a rate hike, the opposite is also the case. In fact, the possibility and fear of negative interest rates have been very detrimental to preferred shares, to the point where this asset class, which is considered to be very conservative, has experienced several difficult years in a row and has fallen by nearly 35% in the very short term.
Benefits of Preferred Shares
There are several advantages to investing in preferred shares. One is to have access to a dividend income that is fixed by prospectus. The eligible dividend is taxed at a lower rate in Canada and Quebec. For example, if you earn $100,000, the tax on $1 of interest will be 45.71% and $1 of dividend will be taxed at only 29.63%. If you are in the highest tax bracket, i.e., above $220,000, the dividend determined is taxed at 40.10% versus 53.30% for regular income. The dividend is therefore taxed 25% to 35% less than the interest income.
A second advantage is the rate of return. Preferred shares have been paying pre-tax dividend rates that are significantly higher than the effective rates on an equivalent bond or debenture over the last many years.
Preferred shares are also great for building a portfolio of securities to capitalize on different interest rate situations. For example, you can choose a basket of adjustable rates to take advantage of rising rates or a basket of perpetuals if you prefer to build an income annuity. We can also combine the preferred equity portfolio with other asset classes for even better diversification.
How to Build a Preferred Share Portfolio
When properly constructed, the preferred share portfolio will almost eliminate the main risk of this asset class: the risk of a loss due to bankruptcy. With diversification, we can effectively dilute the result of the bankruptcy of any one of the securities we hold so that the risk profile of the preferred share portfolio approaches that of corporate bonds.
First, you must weed out issuers that are considered to be of poor quality. At Claret, we like companies that generate consistent and increasing self-generated cash flow. We also like to see certain debt ratios met. To do this, we compile a list of all Canadian preferred stock issuers and eliminate any companies that we deem to be of lower quality.
We then seek to classify the issues by preferred stock category (perpetual, floating rate, reset, etc.). Then, in order to build a portfolio that meets the characteristics we are looking for, we build a matrix in which we select securities on an equally weighted basis (the same amount invested in each security) by the issuer and by security category.
Investment Prospects for Preferred Shares
For a very long time, equilibrium was reached in the preferred stock market when the after-tax dividend rate of preferred stocks was similar to the after-tax rate of corporate bonds. For example, if the interest rate on a Company X bond was 4% and taxed at 50%, this would result in a 2% return to an investor. Therefore, to reach the break-even point in the yield of Company X’s preferred shares, investors would have to be willing to buy them until their dividend rate is equivalent to the bond rate (net of taxes), i.e., a dividend of 2.9% if taxed at 30% (2.9% taxed at 30% = 2%).
Currently, the gross dividend yield on preferred shares is significantly higher than the gross interest rate on corporate bonds. There are two very powerful forces that will drive the market in this direction. First, the newly available Limited Recourse Capital Notes (LRNs) in Canada, which are in strong competition with preferreds, can be issued by companies to deduct interest and make them less costly than dividends, making this financial product more advantageous to issuers. Companies then have the incentive to redeem their preferred shares and issue LRNs on reset dates. Also, investors benefit from investing in preferred shares to take advantage of the tax benefits of eligible dividends.