Preferred Shares: an Opportunity for Taxable Accounts

What are Preferred Shares?
Preferred shares are a form of equity but their role in a portfolio is more like fixed income in two ways:

1. They provide a regular and reliable stream of income. Preferreds are especially attractive to investors with taxable investment accounts since the income is paid out as a dividend, which is subject to a much lower tax rate in Canada (see the excellent article, including historical before- and after-tax returns, by James Hymas in Corporate Bonds ... or Preferred Shares? at prefInfo.com. The exact tax rate difference varies by province and income level as the Ernst and Young tax calculator reveals. The common rule of thumb is that preferred shares should NOT be held in a registered accounts such as RRSP, LIRA, RRIF, LRIF etc. since the tax advantage will be lost.
2. Like bonds they generally react inversely to interest rate changes - when rates go up, prices of preferred shares go down, and vice versa
   

Preferred shares rank behind bonds but ahead of common equity in case of default. Preferred dividends must also be paid before common dividends can be paid. That increases their relative security but the nature of the issuer counts for far more - think of Nortel's now worthless preferreds versus common shares of a regulated utility like Enbridge.

There are many variations of preferred shares that can bemuse, as well as trip up, someone looking at investing in them for the first time:

• temporarily missed dividends might be accrued and paid in full when dividends recommence - cumulative shares - or they might not - non-cumulative shares
  
• some preferreds pay a fixed amount of dividend, others have an adjustable / floating rate
• shares may be paid off in cash at the option of the issuer (redeemable) or the investor (retractable), or may mature on a certain date or never (perpetual), or may be converted to common shares (convertible) or exchanged for another preferred share (exchangeable)

Shakespeare has a good primer on preferreds, including his trading tips and the PrefInfo site has a number of very useful analytical articles by preferred share expert James Hymas.

What are the Risks?
The two main risks are:

• credit risk, the chance that the issuer will be unable to pay the dividends or go into default and not be able to pay even the principal; virtually all preferred shares are rated by the DBRS and/or Standard & Poor's in the same way as bonds.
  
• interest rate risk, the danger that rising interest rates will cause the price of the preferred shares to fall, again in the same way as happens to bonds

Other lesser but nevertheless important risks to consider include:

• tax risk, the possibility that government could change tax rates to reduce the tax advantage of preferreds
• call risk, the choice of the issuer to redeem the shares, which usually happens just at the time when the issuer stands to gain and the investor to lose, i.e. when interest are declining and the issuer can replace high dividend shares with a new issue of low dividend shares
• liquidity risk, the fact that the market for preferreds is less active, which may mean it is harder to sell a preferred than a bond for a good price - the spread between the bid and the ask price is greater.
  

How to invest:

1. Individual Issues - scores of individual share issues from single companies are available. ScotiaMcLeod's Guide to Preferred Shares Winter 2009 lists them all (as of January 2009) grouped by category, with credit ratings, dates for redemption, amount of dividends, yields calculated in several ways, ticker symbols (preferred shares are traded on the TSX) and other data. PrefInfo keeps an up-to-date list of all issues with links to commentary and news items.
   
2. Funds - there is one Canadian ETF, the Claymore S&P/TSX CDN Preferred Share ETF (symbol: CPD, MER: 0.45%), a passive index fund; a few mutual funds such as Hymas' own Malachite Aggressive Preferred Fund (an actively-traded fund available only to investors with portfolios of $1 million or more), the actively managed Jov Leon Frazer Preferred Equity Fund (MER 1.4%), the Omega Preferred Equity Fund (MER: 1.42%) and the AIC Preferred Income Fund; a handful of Closed End Funds, including the actively managed Preferred Share Investment Trust (symbol: PSF.UN), the passively-managed Diversified Preferred Share Trust (symbol: DPS.UN) and the Advantaged Preferred Share Trust (symbol: PFR.UN)

Though it is by no means the only factor to consider, the current c 5.5% pre-tax dividend yield on the S&P/TSX Preferred Share Index substantially exceeds the 3.8% or so yield that is available on Canadian corporate bonds (see iShares' Canadian Corporate Bond Index Fund ETF which tracks the S&P/TSX Corporate Bond Index). This is a reversal of the normal relationship between the two. Maybe preferred shares are worth a look now?