[Mid-Feburary 2007]

In the past few years, preferred shares have been wallflowers in the investment ballroom, while red-hot income trusts garnered most of the attention. But now that many income trusts have been tarnished by the prospect of increased taxation, preferred shares will probably now get a strong second look.

Tax-efficient alternatives for investors seeking income, preferred shares offer returns that generously surpass those offered by bonds and traditional interest-paying alternatives. Recent changes in the dividend tax credit make the asset class even more attractive.

“I suspect there will be a lot of new preferred product coming to market in the next year or so,” says James Hymas, president of Hymas Investment Management Inc. in Toronto and manager of Malachite Aggressive Preferred Fund, which is available to accredited investors. “There is a greater retail appetite, now that the income trust avenue has slowed if not stopped.”

Since the beginning of 2007, Hymas says, there have been new preferred share issues by Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal and Sun Life Financial Inc. amounting to a total market value of about $1.2 billion. The shares were issued with a 4.5% dividend yield; but, with the help of dividend tax credits for investors in the top tax bracket in Ontario, this yield is equivalent on an after-tax basis to a bond that pays 6.3% in interest. (The yield advantage can vary, depending on province of residence and the investor’s tax bracket.)

The primary attraction of preferred shares is their healthy dividends, but it’s not the only advantage. They are called “preferred” shares because they take priority over common shareholders when it comes to payment of dividends, and they also have a prior claim on the issuing company’s assets if it goes out of business. However, preferred shareholders will be paid after bondholders and other creditors are paid. Preferred share dividends are usually “cumulative,” which means if the company misses any dividend payments, preferred dividend payments that are in arrears must be paid before the common shareholders receive anything.

“Non-cumulative” preferred shares do not have to make up for missed dividends, although the dividends payable on the same issuer’s common shares usually cannot be paid if preferred share dividends have stopped.

Many banks have been issuing this type of preferred share because they qualify as Tier 1 capital and, thus, can increase lending capacity. In addition, with non-cumulative preferreds, the banks’ dividend-paying obligations rank after interest obligations on deposits, offering flexibility if the banks fall into financial difficulty and need to suspend payments to investors.

“A lot of people are looking for income, and they want relative security,” says Michael Sprung, president of Sprung & Co. Investment Counselin Toronto, who recommends preferreds that are rated P-1 or P-2 by a reputable agency such as Dominion Bond Rating Service Ltd. “Preferreds are a good place to look, particularly those issued by banks and insurance companies. You’ll have to be somewhat careful with industrials; I wouldn’t be buying preferreds in troubled companies such as GM or Ford.”

The downside of preferreds is that, unlike common shares, they do not give shareholders a say in corporate governance through voting rights attached to the stock. Nor do they usually participate in the growth of a company by increasing the dividend as profit grows. Consequently, there is less opportunity for capital gain on preferred shares. They are typically issued at a face value of $25, $50 or $100, with a fixed dividend for the life of the share, usually paid quarterly.

Because the dividend is fixed, their share prices react much the same way as bonds to changes in market interest rates. They could drop in value if interest rates rise, and may increase in value if rates fall. Some are “floating-rate” preferreds, with dividends that will be adjusted according to changes in interest rates, but these typically trade at a premium to regular preferreds and so offer less yield.

“Preferred shares are like bonds in drag,” says Gavin Graham, vice president and director of investments for Toronto-based Guardian Group of Funds Ltd. “What sets them apart is the beneficial tax treatment of dividends.”

Most preferred shares come with an expiration date, allowing them to be redeemed at the option of the shareholder or retracted by the issuing company. Even “perpetual” or “straight” preferreds can usually be “called” on certain dates at the whim of the company. Investors should note any call provisions, as the terms of the issue could affect how long the security may be held before being vulnerable to a forced redemption and, thus, the loss of the original dividend stream.

@page_break@“There are some high-quality preferreds out there with attractive yields, and after the dividend tax credit it can be damn good income,” says Barnaby Ross, vice president at RBC Dominion Securities Inc. in Toronto. “Nobody should be starving these days. But it’s advisable to have a diversified portfolio to protect against risk with any one issuer.”

Investors can assemble their own mix of preferreds or choose from a handful of closed-end preferred share funds that trade on the Toronto Stock Exchange, including: Diversified Preferred Share Trust, administered by Toronto-based Sentry Select Capital Corp.; Charterhouse Preferred Share Index Corp. , administered by Toronto-based Jovian Capital Corp. through Charterhouse PSI Management Corp.; and Advanced Preferred Share Trust, administered by RBC Dominion Securities.

These funds started out with a predetermined mix of preferreds and are passive, insofar as fund managers don’t trade the portfolio, although they will replace a preferred that is redeemed at maturity or called by the company.

The danger of a passively managed fund is that the distributions paid by the overall portfolio to unitholders could drop if the shares that are called are replaced by others offering lower yields, says Hymas. By contrast, he notes, his Malachite fund is actively traded with a view to yield risk.

There are also a handful of dividend mutual funds that have significant holdings in preferreds, although most have the bulk of their assets in dividend-paying common shares because of a lack of choice in the relatively narrow preferred share market. According to Morningstar Canada, the fund with the largest preferred share holding is the $338-million GGOF Monthly Dividend Fund, sponsored by Guardian Group of Funds Ltd. , which has about 50% of its assets in preferreds but was recently closed to new investors because of a shortage of attractive preferred shares. Graham, manager of the fund, says he has been frustrated by the proliferation of preferred shares that are called “perpetuals” but are actually callable at the discretion of the issuers. He estimates the market for high-quality preferreds at about $21 billion in Canada, but says about $13 billion of these assets are in perpetuals.

“Perpetual preferreds are a one-way bet in favour of the issuer,” he says. “If market interest rates go down, preferred share issuers will call away at their convenience, so they can issue new preferred shares at lower yields and decrease their financing costs. The call feature creates reinvestment risk for the buyer, who would have to replace the income stream at lower rates. With a federal government or provincial bond, the yield may be lower, but there is no danger of it being called away.”

Because of the possibility of a preferred share being called, Hymas says, it is important for investors to analyse the prospective yields to the first possible call date — the “yield to worst.” If the security is trading at more than par value, investors should make sure they will be paid enough in dividends before the first call date to compensate for the premium being paid.

“Yield-to-worst is the single most important measure when buying a preferred,” says Hymas, who offers analysis of individual preferreds and potentially harmful call schedules on his Web site (www.prefinfo.com). “Otherwise, buyers could be paying $27 for something that could get called at $25 — before buyers have received enough dividends to make up for the premium being paid.”

There are several preferreds that have the potential for a negative return for investors buying at current prices, says Hymas. He cites the example of Coastal Income Corp. ’s senior preferred shares, which traded in late January at about $26 with an annual dividend of $1.45, a 5.6% yield. On Feb. 2, Coastal announced it will be redeeming the shares on March 20 at $25.51, including unpaid dividends. Investors who recently bought Coastal preferreds at the $26 market price will end up losing money.

“Investors need to be familiar with the provisions of preferred shares,” agrees Dan Hallett, president of Windsor, Ont.-based fund analyst Dan Hallett & Associates Inc. “They are different beasts. And if they have a defined life or call features, there are valuation implications.” IE


Next: Systematic withdrawal plans