Monday, 17 December 2007

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.

6 comments:

dj said...

Another excellent source of info on preferreds exists on this page: http://www.ritceyteam.com/investment_research.htm

About half-way down under "Guides".

Gail said...

There is a fairly rare Canadian preferred share class known as floating rate preferred shares. These do not change much in value with changes in interest rates. I can confirm this from first hand experience owning both the floating rate and non-floating rate prefs. The value of prefs is in the dividend tax treatment in Canada.
Gail Bebee
author of No Hype - The Straight Goods on Investing Your Money
www.nohypeinvesting.com

CanadianInvestor said...

Thanks Gail. There's always a twist to every story. In effect, the floating rate does the work that the principal value change does in responding to interest rate changes. Though the problem becomes the fact that as dividend payments go up, so do taxes. At least on the non-floating ones, when the principal value drops, there is the opportunity to claim a capital loss.

Congrats on your book btw. From the review in Jon Chevreau's blog, I would think your book worth a look.

CanadianInvestor said...

dj, The reference document you link to the Scotia McLeod is not excellent, it is fabulous! I've downloaded it and stored it in case they should decide to remove it from public access. It has all one could want to know wrt preferreds - from soft-retractables (phew, they have no dysnfunctional erectiles) to fixed-floaters. It is dated January 2007, though it seems some of the tables have not been updated - e.g. references to call dates in early 2006. Still, it has specifics on what at the time was all Canadian issues, information that would take a long time to dig up and compile. There is ample description of terms and the significance of the umpteen features and varieties of preferreds.

There are also some fascinating tidbits and quotes: they favour "... investment grade issues that
offer at least 100 basis points in pre-tax interest equivalent yield over Government of Canada
bonds of equivalent term.", or " Split and structured preferred shares are an excellent
product for investors looking for higher yields."

Mercifully, it is very well written and very readable.

Kudos to you for pointing this out, to Scotia McLeod for publishing it and to author Alex Jemetz for a fine piece of work. I hope they update it in January.

Anonymous said...

Hello Canadian Investor,

In your reply to preferred shares, you mentioned there was a document from Scotia Mcleod that was excellent. I 've search Scotia's website, but was not able to find the document. Are you able to provide a link or it's address?

Thanks

Dave

CanadianInvestor said...

Anonymous,
Phew, I was worried for a momen that they had taken it away. The direct link is http://www.ritceyteam.com/pdf/guide_to_preferred_shares.pdf.
Just copy and paste the address into the browser address space.
Enjoy!

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