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.
Preferred shares, which I argued in a recent column will soon see an attractive buying opportunity, come in different forms, each with their own risks and opportunities. Like the more conventional bond market, there are a variety of instruments that are affected by interest rates and credit quality.
Broadly speaking there are three categories of preferred shares: floating rate preferreds, perpetual preferred issues and fixed-reset shares. All three, although quite different, should be looked at seriously in today’s environment by income-oriented investors.
Let’s discuss attributes of each, and I’ll provide some examples of individual issues that could be put on your watchlist.
Floating rate shares
Rates are set at a spread over three-month T-bill yields and reset every three months. Investing in these shares is like rolling a three-month guaranteed investment certificate or money market instrument - the proceeds get reinvested as soon as the instruments mature. There is one significant difference, however, which provides an opportunity. They trade on the market so the yield can be lower or higher than the original spread because the price can change. Preferred shares traditionally are issued at $25. And just like a bond can be issued at $1000 par, prices can fluctuate.
A good example of the opportunities in the floating preferred market is the Sun Life preferred Series K bonds. They were issued at $25.00 at a rate of the three-month Treasury yield, currently around 5%, plus 2.17%, annualized. That seems like a solid rate today although my view was far less enthusiastic a couple of years ago when rates were historically low. Also, the shares trade at about $20, which effectively increases the yield of the issue to about 9%. Sun Life has been a household name for generations and has a S&P bond rating of AA and preferred rating of A-/P-1(low). A 9% yield is very generous given the inflation picture. This yield will decline if rates fall but will remain relatively high for a short-term instrument. If rates remain higher than market expectations, then the investor can happily collect the high dividend.
Perpetual preferred shares
Like common shares, these have no maturity date and payments are at a fixed amount. Therefore, they are like long-term corporate bonds and should be very sensitive to changes in interest rates. Interest sensitivity increases with average term, but does so at a decreasing rate. For example, a two-year bond would be expected to fall by about 1.9% if rates increased by 100 basis points, while 12-year bond prices would fall by about 9% for a similar rate move, or about a 7% difference for a ten-year difference in maturity. However, for a 1% rise in rates, a 30-year bond would fall between by 15.5% while a 40-year bond would fall about 17%, or only a 150 basis points difference despite having a ten year longer maturity. This is because as we go longer into the future, a dollar is worth far less in terms of discounted cash flow. A dollar today is worth more than a dollar in 2063 due to inflation and the opportunity cost of money.
Therefore, a perpetual preferred should have the interest rate risk of a very long-term bond. In practice, this isn’t usually the case due to various factors. Preferred shares are less liquid than government bonds and therefore their price tends to be stickier. Holders of these issues tend to hold them, so trading volume is low. Also, these issues are usually callable, or in other words redeemable by the issuer at a pre-determined price, usually $25.00, so realistically they are not going to be around forever. Issuers will call the preferred shares when it is to their advantage to do so, especially if they no longer need the capital or have cheaper financial alternatives. The callability feature of a preferred share should result in a higher yield to the investor, all things being equal. That’s because the issuer is given the opportunity to change a long security into a short security if they can refinance more cheaply. In the 1980′s and 1990′s this was a frequent issue for preferred shareholders as rates plummeted. Call features, which allow an issuer to essentially take back the security in the future, are used in falling rate environments. If a company that issued the preferred shares finds that it can refinance to its advantage due to falling rates it is likely to do so if there is a call feature.
An example of a perpetual preferred share is the Power Financial Corp 5.6% Series G preferred shares. The company’s bonds are rated A+ by S&P with an A-/P-1(low) rating on their preferred issues. The issue is redeemable at $25 and non-cumulative. The current yield is about 6 2/3% and is priced at about $21, so being called out at $25 would not be a bad thing. The shares have dropped from a high near $26, or almost 20%. A current yield of almost 7% seems attractive even for someone like me who has experienced much higher rates since I began my career in 1980. The yield is also well above current inflation and hopefully, future inflation.
Fixed-reset issues
The third category of preferred shares is fixed-reset issues. These preferred shares have a fixed rate with a spread above a benchmark rate and are reset every five years. In terms of interest rate risk, they are somewhere between floating rate and perpetual preferred shares. These issues are good for income investors who do not want to take undue interest rate risk of long dated assets but do not want to see their income decline if the central banks start cutting rates, especially if the economy weakens.
An example of a fixed reset issue is the Pembina Pipeline A preferred shares. This issue is for those investors with a taste for some moderate credit risk as the company has a Pfd-3(H) preferred rating from the credit rating agency DBRS Morningstar. The dividend is set at the five-year rate plus 2.47%. The shares trade at around $18.80, well below the issue price, or a current yield of almost 6.5%. The price of the shares has dropped from its recent previous high in 2022 of about $22. I believe Pembina’s dividend is safe and 6.5% seems like a nice rate of return.
These examples of preferred shares are illustrations. There may be liquidity issues and investors need to do their own research or work with an adviser. However, preferred shares are underappreciated right now and merit serious consideration from income-oriented investors.
Read more from Tom Czitron: How markets will adjust to this unfortunate new era of war and conflict
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.