Preferred shares are sometimes described as the unwanted stepchild of most investment counselling firms. This may be an understatement, since even unwanted stepchildren usually don’t have the locks changed on them when they return home from school.
Equity managers and bond managers in firms I have worked for end up fighting over who can avoid managing preferred shares. Given the power dynamics of the average firm, where equities are a bigger revenue producer than fixed income, bond managers usually get stuck with the stewardship of the preferred shares portfolio. In fairness, that is the right decision. Although they are called “shares” and are considered equity for balance sheet management purposes, they are fixed income.
And like other segments of the fixed income market, a buying opportunity may be approaching. But investors need to tread carefully.
Preferred shares are listed on stock markets and appreciate in value similar to a common stock while paying a fixed dividend. While dividend payouts on preferreds generally yield more than a common stock dividend, their shareholders do not have voting rights.
Like bonds, preferreds have maturity dates (unless they are perpetuals, which pay a fixed dividend upon issue as long as it remains outstanding). The issuer of preferred shares is under no pressure or obligation to increase the dollar amount of the dividend payment if the company does well financially over a period.
If a firm cuts its preferred share dividend, it’s a more serious situation than if it cuts its common dividend. In fact, defaulting on preferred shares is a credit event, and indicates a company is in serious trouble.
Preferreds rank below debt, so in the event of a liquidation, they are likely to fair very poorly. All things being equal, bondholders get the proceeds of asset sales before preferred shareholders, who are usually lucky to get anything. Because of this, preferreds theoretically should have higher yields than bonds. The less creditworthy an instrument is, the more yield it should have.
Preferred shares are also subject to different tax rules than bonds, since their payments are dividends and not interest coupons. This affects the current yield, and investors should be aware of their tax situation and invest accordingly. Rules are different in different jurisdictions, and might even differ with respect to specific structures of preferred shares.
Another thing to watch out for is that preferred shares are a relatively small market and therefore have significant liquidity issues. Sometimes one can identify an attractive issue, but be incapable of buying it because it is in “strong hands,” and those holders have no intention of selling. Also, the Canadian market for preferreds is not diversified with respect to industries. Most issues are in the financial services, energy and utilities sectors.
The performance of the S&P/TSX Preferred Share Index recently has been disappointing to say the least. Blame the gargantuan rise in interest rates we have experienced. Preferred shares have fixed dividends the way bonds have a fixed coupon, and are therefore interest-rate sensitive. Their dividend rate and market price must remain competitive with other fixed-rate vehicles. That becomes more difficult as interest rates rise, driving down the price of the issues.
Over the past two years, the S&P/TSX Preferred Share Index has declined by more than 30 per cent, not including dividends. Preferred shares have been a poor long-term investment, too. Consider that the iShares S&P/TSX Canadian Preferred Share Index ETF has posted only a 0.24 per cent total return annually over the past 10 years. Yes, that’s total return – including dividends.
But there have been periods when preferred shares have done remarkably well. From March 20, 2020, to the previous peak around two years ago, the index rose by 66 per cent. It’s had other stellar periods.
So timing is key.
Right now, the chart trend for preferred shares remains negative. Furthermore, given that an expected economic downturn has yet to materialize, some more weakness can be expected.
Still, there’s no denying the yield on the iShares ETF, at 6.25 per cent, is looking attractive. Once we see further progress on inflation coming down and there’s further validation that interest rates have peaked, preferred shares will offer a compelling opportunity.
My best guess is at some point near the end of this year or in the first half of 2024, they will be a buy.
Given the liquidity issues in the Canadian preferred market, I would suggest an exchange-traded fund instead of purchasing individual issues. If buying individual securities, be careful to only consider preferred issues that are creditworthy, such as those found in the financial and utilities sector.
In addition to the iShares S&P/TSX Canadian Preferred Shares Index ETF (CPD-T) another ETF of interest is the BMO Laddered Preferred Share ETF (ZPR-T) which uses a laddered structure to ensure relatively equal dividend payments over the subsequent five years for investors who desire a steady income. The TD Active Preferred Share ETF (TPRF-T), as its name implies, is actively managed ETF. This is a good alternative if an investor wants a portfolio manager with a hands-on approach. Given that the market is so specialized, an active manager may add value.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.