Are preferred shares right for me? Part 1
Preferred, or preference, shares are the investing equivalent of the girl or boy next door: everyone wants sexy but there’s comfort in reliability and practicality after sexy has left you high and dry (and, with due respect to Justin Timberlake, no one is bringing sexy back any time soon). With the markets gripped in panic and uncertainty, preferred shares have become the “it” product for 2009.
I have blogged in the past about preferred or preference shares but I wanted to take this opportunity to explore this product more in-depth in a 2 part q & a format. As usual, please do your own due diligence before buying any investment product.
- What is a preferred share?
Very simply, a preferred share is a type of stock that acts like a bond. Like a stock, it trades on the stock market. Like a bond, it makes periodic payments to the shareholder. In normal market conditions, there is very little movement in price since there is a fixed rate of return on the share (expressed as a yield of the face value of the share; for example, a $20.00 preferred share paying $1.00 per annum has a yield of 5%). Thus, there is no real appreciation of the share since everyone knows what the return will be.
Like a bond, there are typically NO voting rights attached to the share. Your “rights” are to regular payments from being a holder of a preferred share.
The term preferred, or preference, share is derived from the fact that payments from the share are typically in preference to dividends/distributions from common shares (but usually subordinate to debt-holders).
- How is one paid in a preferred share?
Much like dividend payments on common shares, preferred shares pay dividends at set intervals. Most of the preferred share disclosure documents I have read indicate the payments are quarterly.
- Why buy a preferred share. Why not just buy a bond?
Preferred shares tend to pay higher yields than bonds since there is more risk in buying a preferred share than over a bond (remember the bond-holders get paid their interest first in non-bankruptcy situations so they have less risk hence less reward). For example, TD Bank issued a 6.25% preferred share this week which is above what most corporate bond yields are.
Some preferred shares also have convertibility features into other preferred shares or common shares. This allows a shareholder to start at safety, by buying a preferred share, and then converting to appreciation, by converting to a common share, when the time is right (preferred shares do have windows in which you can covert and convertibility rights tend to be limited).
Most distributions by preferred shares are taxed as dividends (having just written about tax considerations when making investing decisions I must sheephisly admit that this is an attraction to preferred shares). Two caveats though: (i) if you buy a preferred share cross border, you may lose the dividend treatment (you have to read the prospectus to find out whether the dividend is treated like a dividend if the issuer is not issuing in the same country you live in) and; (ii) some preferred share distributions are taxed as income. The morale of the story being, research before you buy if you are seeking dividend income without the wide swings in share price.
- How do I buy preferred shares?
Banks are issuing them like free samples at trade shows these days so you can always buy them upon issuance from a broker. Preferred shares also trade like regular common shares on stock markets with their own ticker symbol (here is an example of all of TD’s preferred shares and their ticker symbols)- this is known as the secondary market.
A note about the secondary market though- you can pay more or less than the issuance price. Preferred share trade like stock but, like bonds, are interest rate sensitive. As interest rates go up, their prices go down (since as interest rates go up there may be more attractive fixed income products to purchase). If interest rates fall, prices generally go up.
For those who like to invest in exchange traded funds, there are EFT’s tracking preferred shares.
- The latest preferred shares have “fixed quarterly non-cumulative preferential cash dividend” with “reset” features. What does this mean?
The fixed quarterly part is self-explanatory. There is a fixed rate of return paid quarterly.
Non-cumulative means that if a dividend is missed, it is missed. It will not be made up on a future date.
Preferential cash dividend refers to the fact a dividend in cash (rather than in more shares) is paid in preference to common shareholder dividends.
The reset feature is a recent wrinkle in bank issued preferred shares. The banks have a fixed rate for a period of time (typically from issuance date to the 5th anniversary). On the reset date, the yield is reset to some fixed instrument yield plus a %. For example, in year 5, the new rate can be the interest rate paid by the Government of Canada on its bond on that date plus 2%. Other preferred shares give the shareholder rights to either lock in at a fixed rate (like the example) or a pure floating rate.
…tomorrow, I’ll explore advantages, disadvantages and exit strategies of preferred shares.