The market meltdown has hit preferred shares, but yields are relatively high and the sector is more attractive than usual

By JoAnne Sommers | Nov 2008

Maybe preferred shares need a name change. Despite the modifier, they certainly aren’t winning any popularity contests these days.

It may be largely a function of the wider economic malaise, but preferreds are under siege right now. “There is systemic downward pressure on preferred shares,” says John Nagel, vice president with Desjardins Securities Inc. in Toronto, “the result of frozen credit markets, drying up liquidity and a complete lack of confidence in North American equity markets.” Investors have fled to safe-haven assets such as Treasury bills and government bonds, he adds.

James Hymas, president of Hymas Investment Management Inc. in Toronto and manager of Malachite Aggressive Preferred Fund, agrees. In the wake of the market meltdown, many investors have started dumping preferred shares for whatever they can get.

For example, a recent preferred share issue from Royal Bank of Canada (a fixed-dividend perpetual preferred paying $1.1125 annually) started trading on March 14, 2007, at $25 a share and closed on Oct. 14 at $17.45.

“Preferreds have been badly beaten up over the past 18 months, in part because about 80% of them are financial services issues, which are extremely unfashionable,” says Hymas. “There’s also a retreat from equities and many investors seem to be confusing preferreds with common stocks.”

Preferred shares actually differ from common shares in a number of important respects. As fixed-income investments that pay dividends, they occupy an intermediate place in the investment spectrum between bonds and stocks, paying more than bonds and offering greater safety than common stocks.

The biggest reason to buy preferred shares is for income. Preferreds pay higher dividends than most common shares and provide investors with a tax-advantaged source of income that, in some cases, offers a better yield than bonds of similar credit quality and risk. However, there’s little incentive for non-taxable investors to buy preferreds, according to Hymas, because they’re throwing away the tax benefit, which represents a fair amount of their value.

Preferreds are generally less volatile than common shares and their dividends — usually paid monthly or quarterly — provide a regular income stream. In terms of seniority, they rank after a company’s debt but before the common shareholders. And before preferred share dividends can be reduced, dividends to common shareholders, if any, must be cut to zero.

“If the dividends on common shares fall or are eliminated, preferred shareholders should take note,” says Nagel. “That is usually a sign that a company is on its way to bankruptcy, although it can also indicate that it wants to preserve cash. The key is to find out whether this has happened before and, if so, whether common share dividends were restored.”

Preferred shares are also senior to common shares in case of bankruptcy. If a company is dissolved or wound up, preferred shareholders are paid in full before common shareholders see a penny.

One drawback of preferreds is that, unlike common shares, they are generally non-voting. Preferred shareholders don’t usually participate in company growth because dividends remain the same even if a company doubles in size. There could be an uptick on the share price, but generally it is slight.

Another issue, says Hymas, is that preferreds can be less liquid than bonds: “So, you probably don’t want them to make up more than half of a fixed-income portfolio. They’re also junior to bonds in the event of bankruptcy.”

A great drawback of preferreds, however, is their complexity. They come with a vast array of features, which makes selection a considerable challenge. The most important distinction, says Hymas, is between perpetuals and retractables.

“With a perpetual share, there is no mechanism whereby the shareholder can demand his or her money back from the company. The shareholder must hope the company calls it for redemption, or sell it into the marketplace,” he says. “Retractables have maturity dates, a feature which enables the investor to force the company to accept the shares and pay cash or, in the case of a ‘soft’ retraction, an equivalent amount of common stock priced according to its market value.”

From an income perspective, perpetual preferreds pay substantially more than retractables. For instance, on Sept. 30, a CIBC retractable that should mature in a little less than five years yielded slightly less than 4.7%. At the same time, CIBC perpetual issues were yielding 6.7% or more.