Introduction to Canadian Preferred Shares

An introduction to Canadian Preferred Shares. A primer to help the average investor successfully invest in the Canadian preferred share market.

Written By Canadian Preferreds

On October 19, 2019
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Many Canadian investors are not familiar with preferred shares and so this remains an underutilized sector of the Canadian stock market. On the other hand most investors are familiar with common shares.

Canadian preferred shares are issued by Canadian corporations and pay a dividend on a predetermined schedule to the holder of the shares. Dividends from these share qualify for dividend tax credits when held outside TFSA or RRSP accounts.  A preferred share offers both stock and bond-like features. Similar to a bond the dividend provides the investor with income. Same as common stock they are exchange-traded and the share price fluctuates up or down depending on various events.

In the event of a default, preferred shareholders would have a greater claim on assets than common shareholders, but a lesser claim than bond holders. In other words preferred shares will be redeemed ahead of the common shares but after the corporate bonds. 

Canadian preferred shares are subject to credit risk and there are a number of independent credit rating agencies assigning various levels of credit risk to issuers. The two major bond rating companies are Standard and Poor’s and Dominion Bond Rating Service

Types of Preferred Shares

The structure of Preferred shares is more complicated than common shares and that is one of the major reasons the average investor stays away. At first look this may seem to be major drawback but  it’s really a plus. Once you take the time to understand the 4 major types you realize each one will serve a different need for the investor. Each type offers different benefits and features and you as an investor can move between each type to better satisfy your needs. Switching between the various types can result in great gain for your portfolio. The four major types of preferred shares are as follows.

1. Perpetual

This type of preferred share has no maturity date and pays a fixed dividend upon issue, usually declared and paid quarterly, as long as it remains outstanding.  Shareholders of perpetuals do not have voting rights and the issuers of perpetual preferred stock can typically redeem the shares.

Some of the  perpetual preferred shares come with an additional feature of being retractable. The issuer has the right, but is not obligated to exchange the shares  with the issue’s value at par, payable in cash or the equivalent value in common stock. Par value is the predetermined face value for the redemption at the time of the original issue usually $25.00. This may be a desirable feature for some investors since it provides a defined maturity date.  In most cases due to this feature the yield is a bit lower. 

Picking the right perpetual share is now very easy using our tools.

  1. Use this tool  Highest Yielding Perpetual  to pick the highest yielding perpetual in the Canadian Market Today.
  2. We have also grouped the perpetuals by credit rating for an even easier selection process.  To select highest yielding share today, within each credit rating group use one of these tools:

2. Floating Rate / Variable Rate 

This type of share pays dividends quarterly or monthly with a rate that fluctuates. The dividend is tied to a benchmark like a market interest rate such as Canada’s 3 Month Treasury Bill Yield or the Canadian prime rate.  Additional variations and features of this type include:

  1. A minimum and or maximum dividend, also called  “floor” and/or “ceiling”.
  2. Have a set term and par value, which is repayable in cash at maturity.
  3. Similar to the perpetuals the floating rate preferred share can be retractable.
  4. Can be perpetual, no maturity term.

3. Convertible / Retractable

Convertible preferred’s include an option for the holder to convert the shares into a fixed number of common shares or some other class of share after a predetermined date. This is the same option provide by bonds. Convertible preferred shares are usually priced higher than equivalent fixed perpetuals. They are used by corporations for fundraising purposes. 

Most often the preferred  is exchanged at the request of the shareholder. Less often the issuer will force a conversion if there is a provision that allows for it. The convertible’s value  is ultimately based on the performance of the common stock. The Convertible  provides investors with an option to participate in common stock price appreciation.

Its best to covert and realize an immediate profit when the common share moves above the conversion price.

4. Rate-Reset

Provides a fixed dividend payment where the rate of that payment is reset upon a specific date, typically every five years. Generally, the rate will be a pre-determined spread above a government bond with a similar term. In Canada this is usually a five-year Government of Canada bond.

Once a rate-reset issue comes to term if the share is not called by the issuer the shareholder will generally have two options:

  1. Hold for a new fixed dividend rate reflecting the current interest rate environment. The new rate can be locked-in until the next reset usually for a new five-year fixed rate period .
  2. Exchange /  convert the shares to a floating rate security.

This type of preferred is  the most popular investment structure in the Canadian preferred share market. Its estimated 60% of all available preferred shares listed in Canada belong to this type.

Evaluating , comparing and picking the right reset issue is not easy. There are a lot of factor to consider. Our tools provide you with a  view of all metrics for all shares thus facilitating an easy compare process.  Use one of our compare tools to make the process easier.

  1. Select the Highest Yield Reset . All resets are listed, the set is quite large.
  2. Highest Reset Of Investment Grade Pfd-2h,
  3. Compare Resets Of Investment Grade Pfd-2,
  4. Evaluate Resets Of Investment Grade Pfd-2l,
  5. Rank Resets Of Non-Investment Grade Pfd-3h,

You also evaluate the preferred’s by grouping them in to sectors. Use this version if you know you want to pick the best share within a specific sector.

Share Price Stability

The price of preferred shares move much less than their common share equivalents. Still a number of factors can influence the share price of a preferred share issue. Following is a list of the most common:

  1. Supply and demand. Preferred’s often have light trading volumes. Lack of liquidity can result in exaggerated swings in price. When buy or sell volumes are above average its a chance for investors to pick up shares at discounted prices. Investors need to plan ahead in order to get a fair price when selling and be patient when buying.
  2. Underlying interest rates.  For rate reset and floating rate issues there is a complementary-relationship between changes in interest rates and the price of the preferreds.  In other words when the benchmark interest rate decline,  the dividends offered by these issues also decline and so does the share price. The opposite also holds true.   Perpetual preferred shares have an inverse-relationship with interest rates. Shares will see their market value increase during a period of decline and a drop during a rise in interest rates. Price sensitivity of the preferreds is greater for longer terms and for lower coupon rates.  Preferreds in theory are less price sensitive to interest rate fluctuations than bonds.
  3. Credit quality of the issuer.  Independent agencies assess an issuer’s ability to fulfill its obligations and assign a credit rating. A decline in credit quality can negatively impact the price of preferreds and the dividend policy of the issuer. An upgrade will have the positive effect to the price of the preferred.
  4. Call Risk. Future dividend income stream is uncertain, reinvestment risk for the investor since the issuer often exercises the call provision when interest rates have fallen in order to refinance at lower rates. Callable issues are unlikely to appreciate in price when interest rates fall and possibly decline below the call price given a significant rise in rates.

Advantages

There is a number of advantages when investing in Canadian Preferred Shares. I have compiled the following list of the best know and understood reasons why you should invest in this market segment.

  1. Diversification. Preferred shares have, historically, had a low correlation to equities and bonds, providing important diversification to an investor’s portfolio.
  2. Increased security. Preferred shares are senior to common equities in a company’s capital structure, as such they have a greater claim on assets in the event of an issuer’s bankruptcy, just behind unsecured debt holders.  This provides holders of preferred shares with more security than that of common stock investors.
  3. Fixed or predefined dividend payments. Due to the terms defined preferred share agreements, companies are less likely to miss a dividend payment compared to that of a common shareholder. In addition if there is a cumulative provision any omitted dividends must also be paid before common shareholders receive their payments. Dividends on common shares can go up or down based on the issuer’s financial needs.
  4. Greater tax-efficiency. Preferred shares payout dividend income, which is taxed more favourably than the interest income received from fixed income securities thus offering a significantly higher after-tax yield . Bond distributions are taxed as interest income,  
  5. Lower volatility. Preferred shares tend to trade at their par value during normal market conditions, as a result, they are more stable than common equities, but more volatile than fixed income securities. Preferreds provide a more attractive risk/return profile compared to other fixed income securities,  offering investors a lower volatility alternative for corporate exposure than common stocks, and a higher yielding option than fixed income.

Disadvantages

The disadvantages of holding Canadian preferred shares are nowhere near as important as the advantages. The most publicized disadvantages are listed below:

  1. Liquidity: The size of the preferred share market in Canada is approximately $60 billion but not a lot of that trades on a daily basis. Individual preferreds tend to be quite thinly traded. When buying or selling attention should be paid to the current price which may not reflect the true value of the share. For the savvy investor this is where they can make a great trade.
  2. Small trading block sizes: The bulk of investors in preferred shares are individuals, hence,  the trading blocks are likely going to be smaller.
  3. Lack of pension plan interest: The risk-return trade-off is higher for individual investors than for institutions. Pension plans in Canada don’t enjoy the same advantage as they already benefit from tax shelters.

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