Preferred Shares Are Not As Attractive As They Seem

Last update on June 4, 2015.

 

In recent years, many people have been drawn to the idea of investing in preferred shares.

Preferred shares are "hybrid" investments that behave like stocks in some ways and behave like bonds in others. Like bonds, preferred shares offer regular payments, but like stocks, those payments are in the form of dividends which are taxed at lower rates. When you combine these features with the fact that preferred shares generally yield higher than bonds, it's not hard to see why many people like them.

However, Canadian preferred shares have some pitfalls that investors should know about, especially in our current economic environment. In this article, I'll explain in more detail what preferred shares are, and I'll explain their “pitfalls”.

 

What Preferred Share Are

Let's say you want to start a utility company, and you want to build a power plant that costs $10 million. You can finance this power plant through two types of financing: debt and equity.

Obtaining debt financing means borrowing money with a legally binding promise to pay back the money in the future. For example, perhaps you could borrow $6 million to partially finance the power plant with the promise to pay back the principal (i.e. $6 million) in 10 years time. You'll also have to pay regular interest on the loan until you pay back the principal. For example, if the interest rate is 5%, you'll have to pay $300,000 every year until you pay back the loan in 10 years’ time.

Any missed payment on the loan constitutes a "default". For example, if you fail to make the $300,000 interest payment in year 4, you're in default of the loan. When a default occurs, the lenders have the right to sell your company's assets, such as your power plant, in order to reclaim the loaned amount.

Obtaining equity financing means issuing shares of ownership of the company to investors. Most companies obtain both equity and debt financing. Investors who own shares in the company are called shareholders, and they have a claim on the company's profits, as well as on assets that lenders don't have a claim on.

This last point becomes relevant in the event of a default. For example, let's say that your company defaults and the lenders force you to sell your power plant for $7 million. Since you only owe the lenders $6 million, the $1 million that the company has left, after paying its lenders, belongs to the shareholders.

Unlike debt financing, equity financing doesn't mature; that is, it doesn’t have an end date. As long as the company doesn't go bankrupt, its shareholders will continue to have claims on the company's profits or, if it defaults, its leftover assets.

We can broadly divide equity financing into two categories: common and preferred.

Most stocks that you know of are common shares. Common shareholders have claims on the company's earnings after the company has paid everyone else off, including preferred shareholders.

Preferred shareholders, on the other hand, are only entitled to receive the predetermined dividend payments, and no more than that. However, preferred shareholders have claims on the company's earnings before common shareholders.

For example, let's say the preferred shares of your company pay $400,000 a year in dividends. If the company earns $1 million, then the preferred shareholders receive their $400,000 first, and the common shareholders have claims on the rest ($600,000). If the company earns only $400,000, then preferred shareholders still receive their $400,000, but common shareholders get nothing.

You might wonder what would happen if the company doesn't earn enough to pay its preferred shareholders. In this case, the preferred shareholders won't receive their full dividend. For example, if your utility company only earns $200,000, then preferred shareholders will receive $200,000 and the common shareholders will receive nothing.

With debt financing, we saw that the failure to pay interest would legally constitute a default. However, the failure to pay full dividends on preferred shares doesn't carry the same legal consequences, and preferred shareholders can’t force the company to pay them the full dividends. This makes holding preferred shares riskier than holding debt, and it's part of the reason why preferred shares yield more than debt. However, most preferred shares are issued by large stable companies, so such events are rare.

Another reason why preferred shares generally yield more than bonds is because they are "junior" to lenders in the event of a bankruptcy. Going back to our example, let's say the company owes $6 million to its lenders and that there are $2 million worth of preferred shares outstanding. If the company goes bankrupt and sells the power plant for $7 million, the lenders would receive $6 million of it and the preferred shareholders would receive $1 million. (Common shareholders get nothing.)

As noted, equity financing (both common and preferred shares) doesn’t mature. Because preferred shares can, theoretically, last forever, the CRA considers their payments to be dividends, not interest. This consideration has important tax consequences, as dividends are taxed at much lower rates than interest payments.

In summary, both debt and equity (preferred share) financing result in regular payments to shareholders, but unlike debt, preferred share payments are in dividends, which are taxed at lower rates. Preferred shares are riskier than debt and they don't mature, and both factors are responsible for the higher yields paid by preferred shares.

 

Redeemable And Reset Features

As I said at the beginning of this article, many people are attracted to preferred shares because of their higher yields. In Canada, the two most popular Exchanged Traded Funds (ETFs) that hold preferred shares are the BMO S&P/TSX Laddered Preferred Share Index ETF (Ticker: ZPR), and the iShares S&P/TSX Canadian Preferred Share Index ETF (Ticker: CPD). Going forward, I will refer to them using their symbols.

As of the time of this writing, ZPR yields 4.47% per year, and CPD yields 4.81% per year. By comparison, the BMO Long Corporate Bond Index ETF (Ticker: ZLC) yields 4.13% per year. Depending on your tax situation, it may look as if you could receive over 1% a year more by choosing to invest in CPD over ZLC, when you account for tax advantages.

However, such looks can be deceptive. Unfortunately, most preferred shares have certain features that can cause yields to go lower over time. Let me show you what those features are using some real examples.

The heaviest weighted preferred shares held by ZPR is BCE's "Cumulative Redeemable First Preferred Shares, Series AK". Let's just call these "BCE Preferreds".

The BCE Preferreds are an example of redeemable shares. The following excerpt from the prospectus (i.e. the legal document describing the preferred shares) shows us exactly what this means.

On December 31, 2016 and on December 31 every five years thereafter, the Corporation may, at its option, redeem all or any part of the then outstanding Series AK Preferred Shares by the payment of an amount in cash for each Series AK Preferred Share so redeemed of $25.00 plus all accrued and unpaid dividends thereon up to, but excluding, the date fixed for redemption.

Let me explain why this feature is significant. Currently, the BCE preferreds pay a dividend of $1.0375 per share per year. When they first issued these shares in 2011, each preferred share was worth $25 per share, so the dividend yield was 4.15%.

However, interest rates have gone down since 2011, which means that BCE can mostly likely issue new preferred shares at lower yields. Therefore, if interest rates stay at current levels, we can expect BCE to redeem the shares in 2016 and issue new ones at lower yields. Note that they've already done this many times in the past.

Knowing that BCE will likely redeem the shares at $25, investors have refused to pay much more than $25 per share for BCE preferreds. Therefore, if you buy the BCE preferreds, it may superficially look like you’re buying something that yields roughly 4% per year over the long term. But in reality, you'd be buying an investment that is likely to last less than 2 years.

For investors in ZPR, in the likely event that BCE redeems its preferred shares, ZPR will buy other preferred shares to replace the redeemed shares. The replacement preferred shares (perhaps the newly issued BCE preferreds?) will likely pay lower yields, which means that ZPR's yield will go down as well.

As another example, let's take a look at the heaviest weighted preferred shares held by CPD called the “Non-Cumulative 5-Year Rate Reset Class B Preferred Shares, Series 27”. Let's call these the "BMO preferreds" for short.

As the name suggests, BMO resets the dividend yield of these preferred shares every 5 years. The following excerpt from the prospectus details what that means.

For each five-year period after the Initial Fixed Rate Period ... the holders of Preferred Shares Series 27 will be entitled to receive fixed non-cumulative preferential cash dividends ... The Annual Fixed Dividend Rate for the ensuing Subsequent Fixed Rate Period ... will be equal to the sum of the Government of Canada Yield (as defined herein) on the date on which the Annual Fixed Dividend Rate is determined plus 2.33%.

In other words, every 5 years, the dividend yield of the BMO preferreds is set at the 5 year Government of Canada bond yield plus 2.33%. As of the time of this writing, the bond yielded 0.82%, which means that if the preferred shares were reset today, it would start yielding 3.15% per year for the next 5 years - a drop from the current 4% per year. Since CPD holds the BMO preferreds, we can expect its yield to go down if the BMO preferreds reset to a lower yield.

Unfortunately, most preferred shares issued by Canadian corporations include either a redeemable or a reset feature. As a result, the yield indicated by preferred shares are misleading as they can go down in the future.

Now, astute readers may say that yields on bonds can go down as well, and that's true. However, bonds don't generally have either the redeemable or reset features. Lacking these features, when bond yields go down, bond prices go up, and the rise in prices make up for the loss in yield. For example, the BMO Long Corporate Bond Index ETF (Ticker: ZLC) has gone up by 8% over the past year as interest rates continued to go down. (Read my free book for an explanation of why bond prices go up when yields go down).

By contrast, the redeemable and reset features stop the price of preferred shares from going up too much. For example, nobody would buy BCE shares at much more than $25 a share because BCE can redeem them at that price. Nobody would pay over the odds for BMO preferreds when their dividend payments will decrease. Because of this reason, ZPR went down by around 8%, and CPD went down by around 5% over the past year. As a result, those who invested in ZPR and CPD suffered both a drop in yields, and a fall in prices.

Since interest rates have been going down recently, I continue to expect that the yields of Canadian preferred shares will also go down. For this reason, I'm staying away from preferred shares for now. In the future though, particularly as interest rates go up, preferred shares might become interesting. However, I think we're at least a couple of years away from that at this point.

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