Investing
Preferential Treatment
Investing in preferred shares may be a lucrative way to ride through market volatility.
FROM: MAY-JUN 2003 ISSUE | BY LARRY SHORT
The current low interest rates combined with a general unwillingness to invest in a risky stock market has caused many to turn to new and sometimes elaborate income-generating investment schemes. New income trusts and related products of various forms have received great praise, each being touted as the place to put your money. However, lost in the shuffle seems to be an old idea — preferred shares.
These shares, which have characteristics of both common shares and bonds, have been around since the turn of the century, but have not been as popular in recent years because they have been overshadowed by the new products. With volatile markets creating a renewed interest in income-providing investments, maybe it's time for another look at this tried-and-true investment.
The Differences
Preferred shares are somewhat similar to common shares in that they are considered equity in a company. However, there are some key differences, the major one being that most preferred shares pay a fixed dividend, which is usually much higher than what common shares pay. In return, preferred shares do not participate in the profits of the company. In a year when the profits go up dramatically, the same dividend gets paid out. On the other hand, when profits fall, preferred shareholders get paid the same dividend before any of the common shareholders receive theirs.
In addition, in the event of bankruptcy, preferred shareholders get paid out before common shareholders, although after bond and debenture holders. Preferred shares are essentially safer than common shares but not as safe as a company's bonds or debentures. In return for this relative safety, you enjoy a dividend tax credit that boosts your after-tax rate of return, which can make a significant difference to the cash in your pocket.
Interest-bearing investments like GICs and bonds have very different characteristics than preferred shares. Bonds and GICs pay interest, while preferred shares pay dividends. And bonds are safer since, in the event of dissolution, bondholders would get paid before preferred shareholders. Despite these differences, a simple comparison shows the significant difference in income potential. In the Province of Newfoundland and Labrador, with the tax credit available, a preferred share paying 5.5 per cent annually would provide the exact same cash in your pocket as a GIC or bond paying 6.65 per cent (this will vary slightly from province to province). Unfortunately, nowadays high-quality GICs or bonds paying 6.65 per cent are not available, but high-quality preferred shares paying 5.5 per cent are.
Varying Returns
The returns investors get on their preferred shares depend on the type of preferred shares they purchase. With retractable preferred shares, the purchaser has the right to get his or her money back at a specific time in the future at a set price. In the case of redeemable preferred shares, the company that issued them has the right to give you your money back at some point in the future. You do not have the right to demand it. Perpetual preferred shares have no maturity date and continue to pay out essentially forever.
Normally all preferred shares are issued at $25 per share, and usually the retraction price is also $25 per share. Redeemable prices are at least that price, but can often rise to the $26 level if the redemption date is far into the future. This provides a small incentive for the purchaser to hold onto these shares.
With all three of types of preferred shares, you can sell early, but only at market prices. There is no guarantee that you will get your initial investment back. However, because preferred shares tend to be more secure, pay out regular, high dividends and tend to have a buyout price near the initial issue price, their market price doesn't fluctuate as much as the price of the underlying common shares. If you try to sell out early, you will generally get back about the same as your purchase price.
Still, these shares are best held to maturity, or perpetually. If you purchase preferred shares when interest rates are relatively low and then interest rates rise, the shares will fall in price in the open market, at least to some degree. There is no effect on the payment to you, but if you need to get out early, you may take a loss.
Risk of Default
But what happens if the company that issued the preferred shares gets into financial trouble and there is some question as to whether it will indeed pay the dividend and/or whether it will honour the retraction or redemption? This is the risk of default. When this occurs, the preferred shares tend to act like the underlying common shares; they will fall in price according to the severity of financial trouble.
So, if you are interested in investing in these shares for their income element only, how do you guard against the possibility of default?
Moody's, Standard and Poor's, Dominion Bond Rating Service Ltd., and Canadian Bond Rating Service are companies that provide independent ratings on the safety of various companies' preferred shares. Rating structures vary; for example, Dominion Bond Rating Service rates preferred shares from P1 to P5, with P1 being the most secure. If you stay with P1 and P2 rated shares, you should feel rather certain that these companies will not default. But no system is perfect.
These days it is questionable whether any company can be considered truly stable. Some investors increase the odds of no default further by investing only in the preferred shares of non-cyclical companies like banks and insurance or food companies, where the industry's earnings are stable. Still, this is not an absolute guarantee of security.
Buying preferred shares, rather than common shares, in a blue-chip cyclical company in short-term trouble may actually be a prudent investment. Both common and preferred shares will fall in value, but, in some cases, the preferred shares will continue to pay their full dividend even though their market price has plunged. With your purchase of preferred shares, you buy a more secure, higher-paying instrument that mitigates your downside risk and may provide equal or higher short-term returns than common shares.
Old Faithful
Preferred shares are boring, old, simple and generally stable. That sounds pretty good for many investors right now. As always, deciding which is best for you requires some research and consultation with your investment adviser. If handled with skill, this investment could garner you preferential treatment in exceptional situations.
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Larry Short, B.Comm., CIM, CFP, FCSI, CGA, is a Senior Investment Adviser with TD Waterhouse Investment Advice* in St. John's and is author of In Short: Secrets to Make Your Dollars Grow.