Preferred shares represent ownership in a corporation that have a higher claim on assets and earnings than common stock in the event of bankruptcy, but are subordinate to all outstanding debt obligations. Preferred shares are a type of ‘hybrid’ security as they have both equity and debt like features. The equity like features of preferred shares comes from the ownership position as an equity stakeholder, while the debt features arise from the regular dividend payments and potential end date. Traditionally the price of preferred shares has been less volatile than common stock due to their debt like features. Preferred shares are more suited for investors looking for a steady stream of tax-efficient investment income (dividends vs. interest) rather than those seeking capital appreciation.
- Tax Advantaged Investment Income. The main reason to invest in preferred shares is for investment income. Preferred shares may pay higher dividends than common shares and dividend income provided to investors is treated favorably from a tax perspective relative to other forms of income. Therefore, preferred shares are often able to offer better after-tax yields than bonds of similar credit quality and risk.
- Security of Principal. Greater security of principal may also motivate investors to invest in preferred shares as they rank above the interests of common shareholders, both in their seniority to receive dividend payments and their higher ranking in the distribution of assets if a company is liquidated. However, preferred shares rank below all other forms of debt.
- Priority of Dividends. Preferred shares’ dividend payments can also be “cumulative”, which means that dividends accrue to the holder of the preferred share if the issuer misses a payment. The issuer must pay the missed dividend before any dividends are paid on common shares. Additionally, in order for an issuer to suspend the dividend payment on the preferred shares they must first suspend all dividend payments for the common shareholders.
- Exchange Traded Markets. Unlike bonds, preferred shares trade on public exchanges where the bid and ask prices are visible to all market participants. This is an advantage for investors as it provides greater transparency in pricing.
The risks of investing in preferred shares include interest rate risk, credit risk, call/extension risk, liquidity risk, and the risk of tax law changes that may impact the tax advantaged status of dividend income.
- Interest Rate Risk. Preferred shares are income investments that are impacted by changes in the level of interest rates. The amount of the price change due to a change in interest rates is related to both the term to redemption, dividend rate and type of preferred share. Those preferred shares that have a fixed dividend rate maintain an inverse relationship between interest rates and price – i.e. as interest rates fall, prices rise. However, securities that have their dividend rate adjusted over their lifetime should have a direct relationship with interest rates with prices moving in the same direction as the level of underlying interest rates. Investors in term preferred shares (i.e. those with a fixed maturity date) will lock in a rate of return upon the purchase of a preferred share but will be subject to reinvestment risk on dividends earned and principal repayment.
- Credit Risk. Credit risk involves any change in the creditworthiness of the preferred share issuer. The creditworthiness of an issuer refers to its general financial strength, including its ability to pay dividends and repay principal. The credit quality of preferred shares in Canada is primarily monitored by two independent credit rating agencies: Dominion Bond Rating Service (DBRS), and Standard & Poor’s (S&P). Investors can consult these two agencies to assess the credit risk of investing in the preferred shares of an individual company. Credit risk is also apparent in credit spreads (yield pick-up over Government of Canada bonds). Preferred shares that have no maturity date will be impacted to a greater extent by credit spreads than those securities that have a shorter term to redemption. Credit spreads have an inverse relationship with the price of preferred shares – i.e. widening credit spreads, increases yield, and depresses the price of preferred shares.
- Call Risk. Many preferred shares have a redemption feature built in where the issuer can redeem all or part of the issue. This is a disadvantage for the investor as the redemption will only occur if it is advantageous for the issuer. Preferred share redemptions typically occur when it is cost effective for the issuer to redeem a preferred share that has a high dividend rate and refinance by issuing a preferred share with a lower dividend rate. However, factors such as refinancing options of the issuer, size of the issue, regulatory changes and current market conditions also impact the issuers’ decision to redeem outstanding preferred shares.
- Extension Risk. Although most preferred shares lack a maturity date, they have call dates at which the issuer has ability to keep the security outstanding in the market and continuing paying the dividend. Holders should not expect a security to be redeemed at an upcoming call date as redemption versus extension will depend on the company’s individual situation and financing needs.
- Liquidity Risk. This risk arises from the difficulty of selling preferred shares in the secondary market due to the lack of liquidity relative to most bonds and common equity. Liquidity risk can be measured by size of the spread between the bid and the offer price – i.e. wider spreads increase the risk.
- Tax Risk. One of the attractive features of preferred shares is the lower rate of tax applied to dividend income compared to interest income. The relative attractiveness of this feature depends on the investors’ marginal tax bracket and their province of residence. Changes to provincial or federal tax rates may affect the attractiveness of preferred shares relative to fixed income investments. In general, for investors in lower tax brackets, dividend income becomes less attractive relative to interest income (on an after-tax basis).