Preferred Shares in a Portfolio?

A reader asks what I think of blue chip preferred shares. A good question since I have to admit not having any in my portfolio right now and I have not thought about them a great deal. Maybe I'm missing an opportunity!

Preferred shares are stock of a company. They pay a usually fixed, but sometimes variable, dividend to shareholders. This article titled Why I Don't Use Preferred Stocks from the Motley Fool by David Braze provides more detail, explaining features like participating, callable, cumulative and convertible that can alter their character, sometimes quite significantly. Shakespeare's Primer, linked on the sidebar of this blog, has another excellent explanation of preferreds.

There are two key elements of preferreds to focus on:

1. The fact that they pay dividends not income for tax purposes in Canada (and the UK at least, since in the USA, the tax rules are that they constitute income). The tax status makes a big difference due to the much lower tax rates on dividends as compared to income - e.g. 8% in a middle tax bracket vs 31% (see the table in this post on Canada vs UK tax rates for the rates in the various brackets).
2. Their price moves up and down with interest rates primarily, though a company's default risk does enter into pricing, mostly negatively. In other words, they behave like long-term bonds, moving down in price when interest rates rise, or up when rates fall. How closely they do so is an open matter. I looked in vain on the web for correlation matrices that include preferreds as a potential asset class, so I stand to be corrected. On the basis of their characteristics, for the time being I consider their role in a portfolio to be a tax-advantaged substitute in fixed income for bonds.

I took a quick look today at the current yields on Royal Bank of Canada's W series preferreds (ticker RY.PR.W) - 5.182%, and on a range of investment grade straight bonds of 10 years or more to maturity - 5.0 to 5.6%. Since yields are comparable and since bonds rank before preferreds (a company must pay its bond interest before paying preferred dividends), I see no reason to hold preferreds in a non-taxable account. All my fixed income is within tax-deferred RRSP or LIRA accounts so I don't hold any preferreds at all.

Some people are big fans of preferreds. There is a really good blog by J Hymas called PrefBlog. The fellow is also a regular poster on the Financial Webring thread devoted to Preferreds, a really excellent source of discussion and an opportunity to ask questions of very opinionated and (most often ;-) knowledgeable people. The article Putting Income-splitting to Work by Rob Carrick in the December 14, 2007 Report on Business contains description of how some people are using preferreds to their advantage on taxes.

A critical word goes to investment god Benjamin Graham - a quote from his classic book The Intelligent Investor: "Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one." Mind you, he was writing in the US context, where their tax status is no better than bonds, so perhaps that is too harsh. I cannot complain about anything that can save on tax.