Should I prefer Preferred Shares?

Introduction to Investment Planning – Part 3

Stocks and bonds are the two most common categories for investments, at least for the average “retail” investor like you and me. You may have heard about preferred stock (or shares – the terms are interchangeable) but have wondered why preferred stock is preferred over common stock. Perhaps surprisingly, preferred stock is not necessarily the most popular.

 

Preferred Shares and Capital Structure

Publicly traded companies in Canada raise money to do business in a variety of ways. At its most fundamental, there are just two ways: borrow money or offer an ownership stake in the company. Issuing bonds is one way to borrow money and offering shares in the company is another. Preferred share ownership is a kind of middle way between bonds and common stock ownership.

 

Let’s suppose something we generally don’t like to think about: bankruptcy. If a company is no longer able to carry on business, its assets may have to be sold off so that the creditors, the bondholders, can get back the money that is owed to them. In the capital structure of a company, bonds rank higher than stocks and preferred stock ranks higher than common stock but lower than bonds.

 

Why do Companies issue Preferred Shares?

When a company issue bonds, it must pay the interest or principal owed or else it will be in default. Default is often a precursor to bankruptcy. In the case of preferred shares, the company does not pay interest but dividends. If a company has temporary issues with the availability of cash it can choose to suspend payment of dividends to its preferred and common shareholders without going into default.

 

With the above details in mind, a company may offer preferred shares for sale because it does not want to go further into debt by issuing bonds. Furthermore, because a company has the right to suspend the payment of dividends, it has given itself some room by not increasing the amount of mandatory payments to bondholders.

 

A second reason a company may issue preferred shares is because of the features possibly involved. Callable preferred stock means that the company reserves the right to buy back the preferred shares at a set price (the par price). If the prevailing interest rates have fallen, the company may be able to buy back the current issue of preferreds and sell a new issue at a lower dividend rate, thereby saving the company money in reduced dividend payments.

 

A third reason a company may issue preferred shares is to keep the common shareholders happy. Bondholders earn interest. Preferred shareholders receive dividends. Common shareholders may receive dividends, too, but the main benefit of common over preferred shareholders is the opportunity to participate in the growth of the company. If more common shares are issued, then the opportunity to participate in the growth of the company is diluted. That opportunity is not impacted by the issuance of preferred shares.

 

Why do Investors Prefer Preferred Shares?

In Canada, qualified dividends from Canadian companies enjoy certain tax benefits. If you have non-registered investment accounts from which you are seeking income, dividends from preferred shares provide that combination of income and a tax advantage.

 

As I mentioned earlier, bonds have priority over preferred stock. In order to compensate for that higher risk, companies that issue preferred shares will generally offer a higher dividend rate compared to the interest rate that an investor can receive from bonds. This makes preferred stock attractive to income-seeking investors.

 

Two Common Types of Preferred Shares in Canada

Standard Preferreds

Preferred stock is available in a wide variety of forms, but the classic type is the cumulative perpetual preferred stock. Cumulative means that if any dividend payments have been missed in the past, those accumulated dividends must be paid back before other classes of stock receive their dividends. Perpetual preferreds pay a fixed dividend “perpetually.” They do not mature and theoretically will keep on paying dividends as long as the company remains in business.

 

An illustration of this kind of preferred stock would be one issued at a par value of $25 per share at a dividend rate of 4 percent. If you were to buy 1,000 shares, you would pay out $25,000 and in turn would receive $1,000 per year. The amount paid would hold steady irrespective of the movement in price.

 

Rate-Reset Preferreds

This is a newer type of preferred share in Canada. Unlike standard preferreds which pay a set dividend for the life of that series, rate-reset preferreds pay a fixed amount for a set period, typically five years. Thereafter, the rate is reset based on an established formula. An example of the terms would be the yield for a 5-year Government of Canada bond plus 2 percent. If a 5-year bond yields 1.5% then the rate would reset at 3.5 percent.

 

Should I Invest in Preferreds?

Although the term preferred suggests that these kinds of stock enjoy a degree of popularity that is greater than other shares, their preference is in relation to common shares and relates to their priority in receiving dividends as well as their priority in being repaid in the event of a bankruptcy.

 

Like bonds, the focus on preferred stock is primarily on income and secondarily on capital growth. Also like bonds, the price of preferred stock is significantly impacted by the prevailing rate of interest rates. Standard preferred shares with their fixed dividend, react like bonds. If interest rates go up, the price of the standard preferred shares will decrease because new issues of preferreds will offer a greater dividend rate. A decrease in interest rates will correspondingly lead to an increase in the price of the preferred stock.

 

On the other hand, rate-reset preferreds will act in the opposite manner. As the reset date approaches, if prevailing interest rates have declined, the dividend rate will decline as well, making them less attractive to buyers, while an increase in prevailing interest rates will result in the dividend rate increasing, leading to an increase in value and therefore the price of the rate-reset preferred shares in question.

 

If your focus is on income, a concern for taxation, and you are prepared for the increased risk of loss compared to fixed income investments while simultaneously limiting your ability to participate in the growth of the underlying company, then investments in preferred shares may be of interest. You may buy these shares directly on a stock exchange or packaged as a collection of preferred shares in a mutual fund or ETF (Exchange-Traded Fund).

 

My next post will discuss the equity investment known as common stock.

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.