Perhaps the first step in deciding on what preferred share to invest in is to understand what is available across the capital structure. In other words, assuming you are an income oriented investor, how does a given preferred share stack up against other types of income oriented securities such as GICs, corporate bonds, and some common shares? Each one of these will have a markedly different risk and return profile and deciding on whether any of these securities makes sense for your portfolio largely depends on your personal investment objectives and risk tolerance. So, the right investment may or may not even be a preferred share. But assuming it is a fit for you, and assuming relatively normal market conditions, you should find that preferred shares usually have superior yields relative to GICs and corporate bonds (especially on an after-tax basis if in a non-registered account) and usually better yields than common stocks as well.
If you’ve determined that preferred shares do work for you, a bit more consideration of your personal level of risk tolerance or volatility is in order. This is because not all preferreds are created equal. You will find that they can range from quite stable investments to more volatile ones. As you would expect, the higher quality preferreds with attractive features have lower yields but less volatility and risk, while the lower quality preferreds with less attractive features have higher yields, higher volatility, and more risk. There are a few specific measures that can help with further defining the risk in a given preferred share. The first is the credit rating. Rating agencies give higher credit ratings to those companies that have healthy balance sheets with low debt and ample cash flow to make payments on their obligations, including of course their preferred shares. An investor that has access to financial ratios may want to go one step further than just a company’s overall credit rating and search its debt ratios such as its debt/equity or debt/total capital. Unfortunately there is no one benchmark for these ratios since you cannot compare a company in one industry to a company in another since generally speaking a company in a more stable industry can comfortably have higher debt levels. As such, some work is necessary to understand what a fair ratio is for each industry. And there are many other financial ratios that can help one understand the stability or lack thereof in a business, but they can be beyond the level of due diligence that the average investor wants to do. The alternative to doing this extra work is to just trust the rating agencies’ efforts.
The other aspect of risk that is important to preferred shares is interest rate risk because almost every preferred share is sensitive to changes in interest rates. Certain types of preferred shares increase in value as interest rates rise, while other types fall. For example, floating rate preferred shares benefit from rising rates because their yield typically resets every three months at a given premium to 3-month Government of Canada Treasuries. Their values will fall though with declining interest rates. On the other end of the spectrum, perpetual preferred shares have set distributions that do not move at all with interest rates so in a rising rate environment their yields can lag those of other securities and so they typically fall in value. But when interest rates decline, their fixed distribution becomes attractive and they rise in value. Somewhere in between these two extremes are fixed rate reset preferreds. Their distributions don’t adjust quickly like floating rate prefs, but nor are they fixed forever like perpetuals. Rather, they reset every 5 years at a premium to the Government of Canada 5-year Bond yield. So with fixed rate reset prefs it is important to know when the next reset date is because if it happens to occur in a high interest rate environment then that pref can reset at a higher yield than it previously had and will rise in value to adjust for this. Conversely, if it happens to reset during a period of low interest rates, the pref will reset at a lower yield and fall in value. A more risk averse investor might want to select a fixed rate reset preferred share that doesn’t reset for a number of years, ideally 5, which is the maximum. This way, there is no immediate interest rate risk and your distribution will be stable for a few years at least. There is one unique type of fixed rate reset pref that contains a feature that will both take advantage of higher interest rates and also be protected from lower interest rates – it is called a minimum rate reset. As the name suggests, these securities can reset at higher distribution levels since they do reset every 5 years at a premium to the Government of Canada 5-year Bond yield. However, if the premium plus the Government of Canada 5-year Bond yield is less than their stated minimum rate reset, then the pref resets at that minimum rate. These are very attractive securities for conservative pref share investors, however, the minimum rate reset feature usually means you have to accept a bit lower yield for it.
Given the different types of preferred shares and how they react to interest rate movements, it is important to diversify a preferred share portfolio. There are a number of ways to do this including owning each of the three main types of preferreds (floating, fixed resets, perpetuals) or at least laddering a portfolio of fixed resets whereby the reset dates are spread out as widely as possible. Alternatively, you could offset the specific risks that some preferred shares have with other types of securities in your overall investment portfolio.
Another thing to be aware of with preferred shares is liquidity because the preferred share market is quite small and some prefs in particular have a very limited number of shares outstanding. As such, the ability to buy and sell in a timely manner and at a reasonable spread can be a concern.
One final thing to be aware of is that companies can redeem their preferred shares at certain points in time, typically at $25, so if you’re buying a preferred share that trades above this level (usually because the yield is very attractive) there is the potential for capital loss if the shares happen to get redeemed in the future.
So in selecting a preferred share an investor has to be clear that it is the right security type for their portfolio, that they choose the preferred share(s) that have the qualities that match with their return objectives and risk tolerance, that they diversify their preferred shares or overall portfolio such that they are not overexposed to any one interest rate outcome, and that they are aware of the liquidity and the redemption potential of the shares. With those things in mind a preferred share portfolio can play a significant role in an overall investment portfolio – especially for investors seeking exposure to high quality blue chip Canadian companies that pay attractive tax efficient income.