Preferred shares

Preferred shares in Canada are securities issued by corporations that pay dividends that qualify for dividend tax credits. The shares are "preferred" because the dividends must be paid preferentially before any dividends are paid on the corporation's common shares. The securities are often held by individuals who want to hold fixed income investments in non-registered accounts. Preferred shares have some of the characteristics of common shares (e.g. they are exchange-traded) and some of the characteristics of corporate bonds (e.g. they typically provide a fixed income stream). In the event of a default by the corporation, preferred shares will be redeemed ahead of the common shares but after the corporate bonds.

There are over 200 issues of preferred shares listed on the Toronto Stock Exchange, of which approximately two-thirds are issued by financial companies and the remainder by a mixture of utility, pipeline, communication, industrial, retail and other corporations.

Owning preferred shares can be very attractive for investors who want to hold fixed-income securities in taxable accounts because of dividend income tax credits. This asset class should generally not be held in registered accounts because the tax advantage of the dividend tax credit is lost. However, the asset class is very complicated and inexperienced investors may be advised to seek professional assistance. Trading of the shares on the TSX is often in small volumes, leading to large bid-ask spreads and frequent pricing anomalies. An excellent series of articles by James Hymas on preferred share investing has been published in the Canadian MoneySaver and links to them can be found on PrefBlog.

US preferred stocks and preference shares in other countries will not be discussed here.

Characteristics of preferred shares

 * Credit rating
 * Canadian preferred shares are generally rated by two bond rating agencies: DBRS and Standard and Poor's, which bought the Canadian Bond Rating Service in 2000.


 * Retraction
 * Retraction is the right of the holder of the preferred shares, but not an obligation, to exchange the shares for cash or for the issuer's common share at rates and dates specified in the prospectus. This feature is a desirable feature for the investor since it provides a defined maturity date for the shares. Consequently, retractible preferred shares offer lower yields than equivalent issues without this feature.


 * Redemption
 * Redemption is an option for the issuer of a preferred share to redeem a preferred share at a fixed price at a defined date. This call option works in favour of the issuer and can limit the gains that an investor might otherwise make; due to a drop in interest rates, for example. This a common feature and it requires the prudent investor to calculate its effect by making a Yield-to-worst calculation.


 * Cumulative dividends
 * The cumulative dividend feature means that, if the issuer is unable to make dividend payments, those payments are accrued and must be paid when dividend payments resume. This feature is advantageous for the holder of the preferred share.

Types of preferred shares

 * Perpetuals
 * Fixed resets
 * Split shares
 * Retractables
 * Floaters

Role in a portfolio; income tax effects
An individual's Investment Policy Statement will call for a percentage of the portfolio to be held in fixed income securities. Usually, this entails holding a mix of government and corporate bonds within a tax-sheltered account, such as a Registered Retirement Savings Plan, Registered Retirement Income Fund, Locked-in accounts or Tax-Free Savings Account. If earned in a taxable account, bond income will be taxed at an individual's marginal tax rate for ordinary income. Some individuals do not have sufficient room within their registered accounts for their fixed-income allocation and must elect either to pay tax at full marginal rates on their bond income or to purchase preferred shares, which pay tax at lower marginal rates because of dividend tax credits.

The effect of dividend tax credits varies widely, both as a function of an individual's income and their province of residence; a tax calculator can be used to estimate effective marginal tax rates for different types of income. For example an Ontario resident paying taxes at the maximum rates in 2009 will pay a marginal tax rate of 23.06% on dividend income and 46.41% on ordinary income (for example, from bonds); a BC resident earning $40,000 per year in 2009 will benefit from a negative marginal tax rate on dividends of 10.53% and will pay a marginal 22.7% rate on ordinary income. This means that a preferred share paying annual dividends of 6% would be equivalent to the Ontario and BC examples receiving bond income, respectively, at rates of 8.61% and 8.58% on an after-tax basis. It must be noted that dividend tax credits are non-refundable, which means that to take full advantage of them, the individual must be liable for sufficient federal and provincial taxes. The dividend tax credit grosses up income for tax purposes and may result in higher marginal tax rates (through claw-backs) for individuals who receive government benefits, such as Old Age Security and Guaranteed Income Supplement.

Yield, yield-to-worst
The current yield on a preferred share is calculated simply by dividing the current price by the dividend. However, the yield an investor actually receives over the period he or she holds the share depends not only upon the current yield, but on any capital gains or losses when the share is sold. Many preferred shares carry a series of call options which allow the company to redeem them at specified prices (sometimes declining on a fixed schedule) at specified future dates. The overall yield obtained with a given current price, current yield, call price and call date is called the yield-to-call. Investors should evaluate the yield-to-call of a preferred according to each call date and price. The lowest yield-to-call so calculated is called the yield-to-worst

An Excel spreadsheet to calculate the overall yield the investor obtains, is available here (right-click to download). A Google Docs version has also been created, see Preferred Share Spreadsheets on GoogleDocs: Yield Calculator « PrefBlog.

Risks and sensitivities of preferred shares
Preferred shares, like bonds, will tend to vary in price inversely with interest rates; that is, the price will tend go down as interest rates will go up.

However, this general trend may have many exceptions, depending on the characteristics of the particular preferred. For example, floating rate preferreds, which have a variable yield, should have much lower interest rate sensitivity than fixed-rate preferreds.

Preferred shares may also be affected by untoward events affecting the issuer - for example, a rating downgrade or the halting of the common share dividend.

Since preferred shares can vary in the details of their seniority or common-stock conversion rights (if any), only a detailed analysis of the prospectus can determine the differing risks that may be associated with otherwise similar issues. Prospective investors unwilling to undertake such analysis should either seek professional advice or consider purchasing preferred share mutual funds or exchange-traded funds.

Individual preferreds tend to be quite thinly traded. Buyers or sellers may wish to use limit orders to avoid untoward pricing.

Preferred share index
The S&P/TSX Preferred Share Index is designed to track to the performance of the Canadian preferred stock market.

iShares S&P/TSX Canadian Preferred Share Index Fund
The iShares S&P/TSX Canadian Preferred Share Index Fund is an exchange-traded fund that tracks the S&P/TSX Preferred Share Index. The fund has management fees of 0.45%. It trades on the Toronto Stock Exchange (tsx: CPD). This ETF was formerly known as the Claymore S&P/TSX CDN Preferred Share ETF. The name was changed on March 28, 2012.

BMO S&P/TSX Laddered Preferred Share Index ETF
BMO S&P/TSX Laddered Preferred Share Index ETF has been designed to replicate, to the extent possible, the performance of the S&P/TSX Preferred Share Laddered Index, net of expenses. The Fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index. It trades on the Toronto Stock Exchange (tsx: ZPR). The quoted Maximum Annual Management Fee is 0.450%.

Diversified Preferred Share Closed-end Fund
Formerly there was a closed-end fund called the Diversified Preferred Share Trust from Sentry Investments. On May 24, 2013, the fund was restructured and renamed the "Sentry Global Balanced Income Fund", an open-end mutual fund with a different mandate.

Comparison
Assets = Assets under management (AUM)

Malachite Aggressive Preferred Fund
Malachite Aggressive Preferred Fund (MAPF) is an actively managed fund available only to accredited investors, via private placement. It is managed by Hymas Investment Management Inc. Fees are 1% annually on the first $500,000, 0.75% annually on the next $500,000, 0.50% annually on the balance.