Yesterday, I began a series on one of this year’s “it” products: the preferred share. Today, I continue my analysis into this product in a q & a format.

• What are the risks that my dividend is not paid on preferred shares?

Preferred shares share the same risk as common share dividends: by law, a corporation cannot declare dividends if, after doing so, it cannot meet its obligations as it becomes due. However, since preferred shares have priority to dividend payment to common shares, it is possible for a cash-strapped company to pay dividends to preferred shareholders and not to the common shareholders.

Companies typically abhor not paying dividends to preferred shareholders since it is generally a sign of an impeding financial meltdown (you can screw the common shareholders but not the bond holders or quasi bond holders). Thus, the historical risk has been relatively low.

Most preferred shares issued by banks and insurance companies are also restricted from paying dividends if it would result in the bank or insurance company not having capital adequacy or liquidity (i.e. enough money set aside). Strangely enough, the way for banks and insurance companies to stay out of this restriction is to issue more preferred shares to prop up the balance sheet.

• How do I know if the preferred share is a “sound” investment?

Most preferred shares are rated by credit agencies (for what that’s worth in this day in age). Preferred share yields also work on simple market principles- the riskier the investment, the higher the yield.  Finally, there is plain old due diligence into the general financial health of the business issuing the shares and it industry. For example, I am not sure I would be buying a preferred share issued by a car manufacturer no matter what the yield was.

• What is the implication of banks issuing all these preferred shares?

While it is a relatively cheap source of money, one must remember the issuer has now locked into more dividend payments from its preferred class of shares. Thus, the question becomes can the issuer use the money to return substantially more than its paying out in order to: (i) increase dividends on the common shareholders and (ii) expand the business?

The issue with having a large pool of preferred shares (assuming they all have priority to common shares) is that it squeezes out common share dividend gains since so much money has to be set aside to pay the preferred shareholders rather than ear-marking for dividend increases. The flip-side, of course, is that dividends on common shares can be maintained by issuing preferred shares to prop up balance sheets.

Thus, dividend investors really have a large issue- you know that the only way for some financial institutions to protect the dividend payment is to issue preferred shares but that act may mean it reduces the chances of dividend increases going forward.

The other implication is that since banks are issuing preferred shares to subtantially prop up balance sheets at above bond rates rather than for expansion, guess what is happening with the interest rates on loans going forward? Remember that a bank fundamentally makes money from borrowing from Paul and lending to Peter at a higher rate.

If TD issues a preferred share at a 6.25% yield per annum, it has to start lending at substantially more than that to cover it the cost of paying the preferred shareholder, its administrative costs and make money. What is that rate? 8%? 9%? 10%? This is partially a factor in why you see banks not following the central banks in lowering their prime rates. They can’t with all these preferred shareholders to pay off at investor friendly yields.

In the short term, issuing preferred shares stablizes the banking industry but on the backs of borrowers going forward.  So does this actually slow down the speed of the economic recovery?

• How do I get out?

Preferred shares can be bought and sold like any stock so you can always sell them in the stock market. However, there is not a lot of volume in trades of preferred shares so it may take some time to find a buyer.

Failing that, most preferred shares have redemption and retraction rights.  A redemption is when the shareholder hands in their share for a set price (usually the face value of the share upon issuance plus accrued but unpaid dividends if a dividend is declared in that period). Most new preferred shares will NOT allow any redemption rights for at least 5 years as part of the cash hoarding moves companies have had to undertake.

A retraction right is the issuer’s right to buy back the shares. Typically, if the retraction right is triggered not soon after the issuance date of the preferred share, the shareholder is paid the issue price plus a premium. After a longer period of time, the retraction price is most likely the issuance price.

Some preferred shares do have maturity date like bonds when the shares have to be bought back. Thus, if you sit and do nothing chances are, eventually, your shares will be bought back.

• What are the advantages and disadvantages of preferred shares?

Advantages: fixed rate of return, convertibility features, relatively low volatility. It is safe and predictable.

Disadvantages: sensitive to interest rate changes, not a great inflation hedge (assuming interest rates rise to combat inflation), no upside, little liquidity, many exit strategies are forced onto the holder.

….preferred shares are neither inherently good or bad in and of itself. In some portfolios, they are welcome additions. In others, it may not match the goals of the investor. As with everything in life, it comes down to each individual’s context.