Shakespeare's Preferreds

Preferred Shares

What are Preferred Shares?

Preferred shares are called "preferred" because their dividend must be paid before the common-stock dividend (if any) is paid. They can be a particularly important source of income for those whose net income (including the dividend "gross-up") falls in the lowest tax bracket, since, as stated earlier in the section on Canadian Investments, the dividend tax credit reduces the marginal tax rate to a few percent. They should not be held in a registered account (except for COPRs, see below) because the advantage of the dividend tax credit is lost. Also, retirees in high tax brackets, particularly those subject to OAS clawback, should avoid holding preferred shares because the dividend gross-up will increase the clawback. The dividend gross-up may also penalize other retirees who have income-based benefits. If in doubt, consult a professional tax advisor.

Unfortunately, preferreds are a complicated area in which paid assistance of some type will be of considerable help to the do-it-yourself investor. Nevertheless, because of the attractiveness of dividend investing for those in the bottom tax bracket, and because of inefficiencies in the preferred share market, careful investors can be well rewarded as long as they pay attention to detail.

Canadian Moneysaver has occasional articles on preferreds. Some of the articles may be available online periodically.

High-quality corporate preferreds are similar to bonds in terms of risk, and can be considered as fixed income (i.e. low risk) for asset allocation purposes. They can be used instead of bonds in non-registered accounts.

Definitions

Convertible preferreds can be exchanged for common stock after a certain date and at a certain ratio (which often depends on pricing at the conversion date). Because of this feature, the price is tied to that of the common stock and will fluctuate more than that of non-convertible issues.

Cumulative preferreds continue to accrue unpaid dividends if the company (temporarily) halts the dividend payment. When dividend payment is reinstated, the accrued dividends must be paid. This is a desirable feature; if a dividend is missed in a non-cumulative preferred, it is gone forever.

Exchangeable preferreds allow the purchaser to switch them for another preferred issue or the common stock. This is a desirable feature because it gives the purchaser an exit.

Floating-rate preferreds have a payment that is linked to a certain rate, usually the bank's prime rate. These preferreds vary less in price than do straight preferreds.

Redemption is the company's right to purchase, or call, the shares from you, at (or after) fixed times, and at fixed prices. Often, the shares can be redeemed at a certain initial time ("first call") at a premium which diminishes over a multi-year period. The company will call the shares from you if conditions are to its benefit - that is, if it feels it can get money at a better rate [i.e. by calling a high-yielding preferred and issuing a new one at a lower rate]. For that reason, you should always focus on yield-to-call (or yield-to-worst, which is the lowest calculated yield when several call options are available) when evaluating a preferred.

Retraction is the right, but not the obligation, for you to sell the shares back to the company at a certain time and price (given in the prospectus). Soft Retraction allows the company to give you common shares, rather than cash, for your preferreds. Retraction is a desirable feature absent in many preferreds.

Straight preferreds pay a fixed dividend, i.e. they are not floating-rate.

Most preferreds combine many of the above features.

Yield-to-call is the mathematical calculation that takes into account the present date and price, the call (redemption) date and price, and the dividends due over that interval. If the stock can be called over a multi-year period at a diminishing premium, the yield-to-worst calculation is considered the most important. A preferred currently trading above its call price will have in a capital loss if called; this reduces the yield-to-call. This data is available from your broker, or can be calculated on a spreadsheet or financial calculator. An Excel spreadsheet that performs the yield-to-call calculation is here (right-click to download). The yield-to-worst can be determined by entering all different call dates and prices and noting the lowest yield.

Yield-to-redemption or yield-to-retraction takes into account the price at (final) redemption or retraction, current price and date, and dividends paid in the interval. They are of less importance than yield-to-call and yield-to-worst.

Sources of Information

An excellent on-line source of information on preferred shares is prefInfo.com. Preferreds can be sorted by rating at DBRS. A rating of Pfd-1 or Pfd-2 is best for the conservative investor. Refining the list requires cross-checking the preferred's rating at Standard and Poor's. To access the ratings, select Canada/English from the top left navigation bar. Individual credit ratings can be found by a company search (free registration required). Investors should also obtain the prospectus (or the annual report, which summarizes the outstanding preferreds) from Sedar. The DBRS ratings of Pfd-1 and Pfd-2 are equivalent to the Standard and Poor's ratings of P-1 and P-2. If the ratings from DBRS and Standard and Poor's differ (a "split rating"), use the lower rating.

Information can also be found in printed sources. The Financial Post Data group publication "FPEquities - Preferreds and Derivatives" is an out-of-print source that might be found in your local library. The newsletter The Money Reporter (available from Advice for Investors) has recommended preferreds in every second issue and a list of preferreds periodically. You can also obtain a list of recommended preferreds from your broker. The online sources (particularly the prospectus or annual report) can then be used to refine your initial list.

Buying and Selling Preferreds

Many preferreds are thinly traded. Considerable care is required in buying and selling to avoid disadvantageous pricing. A bad trade can cost you six month's income. A very bad trade can cost you a year's income.

One way to get a good price is to put in a good-till-cancelled limit order at a favourable price and wait to see if it gets filled. If you are buying, make sure that you don't use the money for something else! If you do, cancel the outstanding order immediately. If your price is too far off the market, it won't get filled; the market maker will buy your target first.

Avoid all-or-none (AON) orders, since they may not get executed even if the preferred trades below (on a buy) or above (on a sell) the AON price. A limit order is better.

Another strategy is to monitor the price of your selected preferreds and put in a market order when pricing is favourable to you. Many preferreds sell off just after the ex-dividend date as unwise investors unload; this is often a buying opportunity. Conversely, don't sell a preferred right after its ex-dividend date; wait a while or sell before it is ex-dividend (i.e. while it is cum-dividend). Buying pressure - say, after a bank rate cut - may also temporarily raise the price of the preferred; this may represent a selling opportunity. Always monitor the yield-to-call (or yield-to-worst) and use that, rather than the nominal yield, to determine whether or not pricing is advantageous. The yield-to-call can be calculated from a financial calculator or with spreadsheet functions. A very high nominal yield usually means that there is something wrong with the security; this will often be an imminent call.

If you need to sell a preferred immediately to raise cash, use a market order and take your lumps.

Straight preferreds will tend to track the long (30-year) bond in price. When bond prices go down (i.e. interest rates go up), so will preferred prices. At the time of writing (January, 2002), interest rates seem more likely to go up than down. Straight preferreds should be avoided.

Floating-Rate Preferreds

Floating-rate preferreds have dividend yields that track current interest rates. The yield is usually calculated as a percentage of the current prime rate. A preferred share often has a floating-rate provision that comes into force if the issue is not redeemed at a certain date.

Some floating-rate preferreds have a rate adjustment mechanism that adjusts the dividend if the share price falls outside a certain range. This feature is usually desirable, and should improve the price stability of the preferred. Since the mechanism of the dividend adjustment may at first appear obscure, I will give an example based on the most common adjustment mechanism.

Example 1: ABC Corp issues a preferred share with a face value of $25.00 and an initial fixed rate of 5.5%. This gives an annual dividend of $1.375, paid quarterly. On a specified date, this issue is redeemable at $25.00. It is not redeemed and, in accordance with its prospectus, converts to a floating-rate preferred, callable at $25.50, and with an indicated annual dividend of 80% of prime, payable monthly. The dividend is to be adjusted if the share trades outside a certain range (say $24.875-$25.125) for more than a specified period in each month. The maximum adjustment in any month is 4% of prime and the adjusted dividend rate can not be less than 50% of prime or more than prime.
At the time of conversion, prime was 4.5%. The initial annual floating dividend is 0.045*0.80*$25.00, or $0.90 - a significant drop from the previous $1.375. The share price therefore drops well below the $24.875 floor. The following month, the indicated annual dividend is raised by the maximum amount of 4% of prime. This is calculated to be 0.04*0.045*$25.00, or $0.045, and gives a new annual dividend of $0.945. The preferred price still remains below the $24.875 floor, so the dividend is raised the following month to $0.990, then to $1.035, then to $1.080, and finally to the maximum of $1.125. The share price increases with each dividend increase, and then stabilizes. The preferred share is now paying an indicated annual dividend of 100% of prime.

Floating- rate preferreds should see less price pressure than straight preferreds in the event of interest rate increases, but, because there is a delay in the setting of the floating rate, any dividend rate increase will lag changes in the prime rate.

Floating-rate preferreds can provide a tax-effective alternative to bonds in a non-registered portfolio. However, in addition to problems associated with poor liquidity, a preferred issue may suffer a substantial price drop if the company's credit rating is downgraded - even if the preferred dividend is not at risk. This means that there may be no favourable exit price unless or until the company recovers. Individuals wishing to hold floating-rate preferreds in their portfolios should consider spreading their holdings amongst several high-quality issues from different companies in different sectors, and limiting each holding to 1-2% of the portfolio. If these precautions are taken, floating-rate preferreds should act as a separate asset class, providing modest income whilst reducing portfolio variation.

Split-Share Preferreds

Split-share preferreds are issued when an investment banker acquires the stock of one or more companies and uses the stock to underwrite a closed-end fund. This closed-end fund then issues both capital and preferred shares. The preferred shares get the dividends from the underlying companies. The capital shares get most or all of the price appreciation. The underwriters get a fee and the lead underwriter usually gets a management fee. Split-share offerings have been made by splitting the shares from banks, pipelines, utilities, and life-insurance companies.

The preferred-share investor should be wary of several aspects of the preferreds.

If the issue is from a single company, the dividend could be cut. This happened a few years ago with Trans-Canada Pipelines. Multi-company split shares give better diversification.
If the underlying companies rise sharply in price, the capital share owners will use a yearly retraction feature to sell their shares back to the underwriter, who will call a corresponding number of preferred shares. If this happens, the preferred share owners may see a significant fraction of their shares - perhaps as much as 30% to 50% - called at the retraction date (these dates are usually on each anniversary of the original issue date). These large retractions disrupt income planning.
If the preferred shareholders have paid over par for the preferred shares, then they will incur a capital loss on shares redeemed at par. This problem is particularly important for split-share preferreds issued some time ago and which have very high apparent yields because of subsequent dividend increases in the underlying common shares.
The dividend payout may partly be a return of capital. The prospectus should be consulted to see if the underlying shares provide sufficient dividend coverage.

Hybrid Securities (COPRs)

Hybrid securities called COPRs (Canadian Originated Preferred Securities) became popular a few years ago, and have been offered by several companies. These instruments are basically junior subordinated debentures from the issuing companies, and pay interest, not dividend, income. They should be held in an RRSP. They are non-cumulative and the dividend can be halted for up to five years, but only if the common stock dividend is halted first. Most of them are callable starting in 2004.

These issues will drop in price if interest rates rise, and should not be held in a rising interest rate environment. They are subject to mispricing just after the ex-dividend date, and can be traded for modest gains if careful attention is paid to pricing.

U.S. Dollar Preferreds

Some Canadian companies, including several of the big banks, offer preferred shares that pay dividends in US dollars. These dividends still qualify for the dividend tax credit, which is based on whether CRA considers the company to be Canadian, not what currency is used to pay the dividend.

The preferred shares of US companies do not benefit from the dividend tax credit and have the same tax treatment as interest income.

Note: In "Fifty Plus" magazine, August 2002, p. 45, author Gordon Pape points out a problem with U.S. dollar preferreds that are redeemed by the issuer. The owner will be taxed on a "deemed dividend" that reflects the change in the Canadian dollar value on the preferred since it was issued (not since it was purchased). A capital loss will also be incurred, but the individual taxpayer will have a net tax increase if in a bracket where the tax rate on dividends is greater than the tax rate on capital gains (losses). To avoid this tax, says Pape, shareholders should "always sell U.S.-dollar preferreds back into the secondary market before redemption".