Most investors know something about stocks, a little bit about bonds and, of course, GICs. But what many investors don’t know a whole lot about is a type of investment that’s somewhat like a stock and a bond – these are called preferreds.
What are preferreds?
A preferred share is a special type of stock that regularly pays a set amount of money out of the company’s profits, called dividends. They’re called preferreds because holders get preferential claim to the profits ahead of common shareholders.
How they work
Unlike common shares, preferred shares don’t give investors the right to share in a company’s fortunes. Your rights end at getting a set amount of dividends and having a prior claim on the company’s assets ahead of common shareholders if the firm goes out of business.
Only if the company misses a set number of dividend payments do preferred shareholders have a right to vote in the company’s affairs. If the company earns a profit again, preferred shareholders are usually entitled to get all the missed dividend payments paid to them before common shareholders get any. Those shares that don't have this provision are called non-cumulative preferreds.
In many ways, preferred shares are like bonds, except they don’t have a set maturity date. They’re often issued at a face value, usually $25, $50 or $100.
The fixed dividend payments – mostly paid every three months – are like a bond’s interest payments. And they react the same way to changes in interest rates as bonds do. If interest rates go down, preferred share prices go up, and vice versa.
The return on preferred shares is called a yield. To calculate the yield, first figure out the dividends per year as a percentage of the price you paid for the shares. For example, if you paid $25 for a preferred that pays a $1.75 dividend per year, then your yield is 7% ($1.75 divided by $25 per share X 100 = 7%).
The risks
Since preferred share prices react to swings in interest rates, you could get less than you paid for your shares if interest rates increase and you have to sell. This is because the yield on your preferreds likely won’t be competitive with other investments now that rates have gone up.
Therefore you’ll likely have to drop the price so that the fixed dividend gives prospective buyers an attractive return. There’s also the risk that the company will do badly and not have money to pay dividends. If this happens, you might also have to sell your shares at a loss. Other investors won’t be interested in a preferred share that isn’t paying dividends. If the company goes bankrupt, you’ll likely lose money on your preferreds, but likely less money than if you'd bought the firm's common stock.
Preferreds entitle you to a set amount of money if the company goes bankrupt. However, you’ll only be paid after bond holders and other creditors have been paid.
The rewards
Yields on many preferred shares are higher than those of other fixed-income investments like bonds. This is because the return is less assured; so the higher yield compensates investors for taking on added risk.
Since preferred prices respond in opposite directions to interest rates, investors can make a profit by selling them after interest rates have gone down. The income investors get from the preferred share’s dividend is taxed less heavily than interest on bonds, leaving investors with a bigger actual return.
Over the long term, preferred shares have performed better than ordinary bonds, but not as well as stocks, according to Kenneth Winans. In his best-selling book, Preferreds: Wall Street’s Best-Kept Income Secret, Winans notes that, from 1900 to 2007, corporate bonds returned an average 6.3% per year, while preferreds returned an average 7.4%. Commons stocks performed best during this timeframe, with an average 10% per year.
After-tax return
It’s a difficult time for income investors. Interest rates are at historic lows, making traditional safe haven securities like GICs less attractive. The big banks are currently paying less than 2% on five-year terms – a level we haven’t seen since the 1950s. But for income-seeking investors, preferreds are good option. In many cases, preferreds offer higher yields than GICs, plus investors get a tax advantage through the application of the dividend tax credit.
This means higher after-tax returns. For example, a top-bracket Ontario taxpayer pays tax at a rate of 46.41% on interest income received in 2009. If the money is received as dividends instead, the effective rate is only 31.34%.
This isn’t just a rich person’s tax break. In fact, the credit works most effectively for lower-income taxpayers. If you have taxable income of between $15,659 and $36,848 in Ontario in 2009, your effective rate on dividend income is only 3.23%. The rate varies depending on what province you live in, but the principle is the same across Canada.
Rated as to safety
Like bonds, preferreds are rated as to safety by the national bond rating agencies, with Pfd-1 the highest rating (safest), and Pfd-5 the lowest (most risky).
Lower-rated preferreds usually offer a higher yield, perhaps much higher than normal, but you have to be very careful if you decide to invest in them. The low rating is a red flag; it means the company is likely in financial difficulty. If you come across a preferred share with an extraordinarily high yield, you can be sure there's a good reason for it. No one gives away something for nothing.
You can find preferred share ratings by going to the website of Dominion Bond Rating Service.
Types of preferreds
There are several types of preferreds and you should understand the differences between them before investing.
- Fixed rate preferreds: The dividend payment is fixed and doesn’t vary over the life of the issue. As a result, these preferreds are more interest-sensitive and their market price will be more affected by actions taken by the Bank of Canada.
- Floating rate preferreds: These pay a dividend which fluctuates according to market conditions, based upon a formula. For example, the dividend may be calculated as a percentage of the bank prime lending rate.
- Non-cumulative preferreds: With regular preferreds, if dividends are missed, they have to be made up later before common stock holders can receive any payment. This isn’t the case with non-cumulative preferreds, which are often issued by the big banks; so they carry a higher degree of risk. However, non-cumulatives usually offer a better yield than regular preferreds, so you’re compensated for the additional risk.
- U.S.-pay preferreds: Some Canadian preferred share issues are denominated in U.S. dollars, and pay dividends in that currency. The banks are especially active in issuing this type of stock. U.S.-pay preferreds are eligible for the dividend tax credit and offer an opportunity for currency gains at times when the Canadian dollar is falling.
- Convertible preferreds: These allow investors to convert to shares of the company's common stock according to a specific formula. This feature can produce significant capital gains if the value of the common stock rises well beyond the conversion price.
