Preferred Share Investing
What are Preferred Shares?
Preferred shares are a class of shares of a company which have special rights or restrictions in comparison to the common shares. Depending on the features, a preferred share can resemble either ownership or debt of a company. Such features impact their liquidity, prospective returns and risk.
Preferred Share Characteristics
For a private company, preferred shares can be tailored to meet the unique needs and situation of each company owner. For example, for those owners involved in the business operations might have voting shares (which could contain multiple votes) or in dealing with a buy-out of the business that the retiring owners have profit participation that reflects a return on the value of the business at the time of the transition.
For a public company, preferred shares typically resemble a financing alternative and might have the following characteristics:
- Non-Voting – the preferred shareholders typically don’t have a right to vote for directors or to vote on company business. An exception may exist where preferred shares become voting in the event their dividend is not paid.
- Non-Participating – the preferred shareholders typically don’t have a right to share in the company earnings; just the specified dividend.
- Dividend Claim Priority (cumulative entitlement to dividends) – as financing, the preferred shareholders will desire a right for any unpaid dividends to accrue and must be repaid before dividends can be paid on common shares. This feature provides greater certainty in preferred shareholders receiving regular dividends.
- Asset Claim Priority – as financing, in the event of liquidation, the preferred shareholders would want to be paid their par value before any amount of assets are paid on common shares. This feature provides greater certainty in getting back their capital.
Depending on the financial strength and prospects of the business, certain characteristics may be added to make the shares more marketable or to provide the company with greater financing flexibility:
- Retractable (also known as a Term Preferred Share) – Does the owner of the preferred shares have a right, at some period of time, to force the company to buy back their preferred shares?
- Convertible – Does the owner of the preferred shares have a right to convert the preferred shares to a set number of common shares?
- Redeemable / Callable – does the company have the right to force the preferred shares to be sold back to the company at a set price or for an equivalent amount of common shares?
- Fixed or Variable (Floating) Dividend Rate – Is the dividend rate a fixed dollar amount or does the dividend rate vary – for example, is the dividend rate 4% plus the yield on a 5 year government of Canada bond?
- Warrants – Were the preferred shares sold as a unit with warrants on the common shares?
Advantages of Preferred Shares
- Higher Income
Preferred shares tend to provide a higher dividend yield compared to the company’s common shares. This makes sense as one would want a higher yield if they are to give up a right to share in the company earnings.
When compared to bonds, preferred shares tend to offer higher levels of pre-tax income for similar credit quality. This makes sense as one desires more income to make up for lesser guarantee of income and return of principal. When you factor in the tax preferred income of dividends of Canadian corporations to interest income, the after-tax returns from dividends tend to be substantially higher.
- Greater security than common shares
Preferred shares provide a more secure return than that of common shares as the preferred shares come with a a pre-determined dividend rate and are paid periodically (typically semi-annually or quarterly) in accordance to the prospectus, shareholder agreement or articles of the company. Although a company can decide not to pay a dividend to preferred shareholders, this is not typically done unless the company is in financial difficulty.
Preferred shares are provided with some protection of capital as they are ranked senior to common shares in the event of company liquidation.
- Lower volatility than common shares
Generally speaking, under normal company operating conditions, the preferred shares of a company tend to trade around their par value should its dividend rate be competitive to other comparable credit quality investments. This stated dividend should also help support the value of the preferred share on a market downturn compared to the common share.
But compared to a bond of the company, a preferred share has less certainty of its income receipts and return of capital, so its stock price tends to be more volatile.
Preferred Shares Risks
The main risks of investing in preferred shares include:
- Insolvency Risk
Preferred shares rank only above common shares in the event the company were to become bankrupt and assets liquidated. It may be questionable whether any assets remain after all other creditors have been paid to go to the preferred shareholders.
- Non-payment of Dividends
Should the company experience financial distress, it may choose not to declare dividends on the preferred shares. Where the preferred shares are non-cumulative, the missed dividends are lost to preferred shareholders.
- Call Risk
The majority of publicly traded preferred shares are callable (or redeemable) at the option of the company who can forcefully buy back the shares on or after a set date at a set price. Where the preferred shares are bought at a price above its redemption price, then one is at risk in this amount in the event of the shares being called.
The redemption price is fixed according to a schedule for which there may be a redemption price premium over the shares’ par value. This premium declines each year until the call price equals the preferred share’s par value. Some preferred shares have a “call protection” feature where they cannot be called for at least five years after they are issued.
Preferred shares are likely to be redeemed if it is in the company’s interest to replace the preferred shares with a lower cost form of financing. The company will compare the cost of a non-deductible dividend payment to tax-deductible interest payment for debt financing or a cheaper preferred dividend issue. Redemptions typically occur where interest rates have been declining and the dividend rate on the existing preferred shares become high relative to other alternatives at that time.
- Liquidity Risk
This risk arises from the difficulty of selling preferred shares in the stock market due to a lack of liquidity. Liquidity risk can be measured by size of the spread between the bid and ask prices. The wider the spread, the more it costs you to buy or sell the preferred share. As part of liquidity risk, shares may be thinly traded (with only a small number of shares offered to buy or sell). As such, your order may take time to fill or you might have to buy/sell the remaining amount of your order at worse prices.
- Interest Rate Risk
Preferred shares are income investments that are impacted by changes in the level of interest rates. There is an inverse relationship between interest rates and the price of preferred shares. As interest rates rise, the market price of the preferred share would need to fall to offer investors a competitive rate. The amount of the price change due to a change in interest rates is related to both the term to redemption and the dividend rate. In general, the longer the term and the lower the dividend rate, the greater the interest rate risk.
- Credit Risk
Credit risk involves any change in the financial strength of the company as to its ability to pay dividends and repay principal on maturity. Credit risk may be apparent in credit spreads (yield pick-up over Government of Canada bonds). Preferred shares which have a longer term (like in perpetual shares that don’t have a retraction feature) will be impacted to a greater extent by credit spreads than those that have a short term to retraction. Credit spreads have the same impact as interest rates where widening credit spreads increases yield and depresses the price of preferred shares.
- Lack of Capital Gains
Preferred shares tend to be non-participating with no right to share in the earnings of the company beyond its promised dividend. As such, if the company’s prospects were to positively change, the upside potential of preferred shares tends to be rather limited compared to the upside potential of common shares.
- Tax Risk
One of the attractive features of preferred shares is the lower rate of tax applied to dividend income of Canadian corporations compared to interest income. The relative attractiveness of this feature depends on your marginal tax bracket and your province of residence. Changes to provincial or federal tax rates may affect the attractiveness of preferred shares relative to fixed income investments.
It is prudent to buy several preferred shares to reduce company risk. Ideally we would like to buy at least ten different preferred shares offered from different companies with the same amount of cash being allocated to each preferred share. We would also have preferred shares as one type of investment, in addition to common shares and bonds, as part of a portfolio.
Given the tax preferred income, we would generally look to having preferred shares be owned in personal investment accounts or company investment accounts and hold more heavily taxed investments like bonds in tax deferred (RRSP, RRIF, TFSA) accounts.
The Next Step
Preferred shares have a place in any person’s portfolio. If your portfolio doesn’t include preferred shares, you might want to contact me for a no-obligation second opinion of your portfolio by calling (604) 288-2083 or by email at email@example.com
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.