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.

@page_break@Preferred shares can have cumulative or non-cumulative dividends. Cumulative dividends mean that if the company omits a dividend, the company owes it to you retroactively when dividends are reintroduced. Non-cumulative means that when dividends are suspended, they’re gone.

“Most investors won’t buy non-cumulative preferred shares in a company unless they’re assured that it will be around forever,” says Nagel. “Banks issue non-cumulative preferreds because if they aren’t paying dividends, the economy is in real trouble. That’s what has happened with investment banks and broker dealers in the U.S. recently. Regular banks have continued paying dividends, however.”

Another way to classify preferreds is as floating or fixed-rate: fixed-rate preferreds provide for a set or “fixed-rate” dividend, which is usually declared and paid quarterly. This can be set either as a fixed dollar value dividend or a stated percentage of the par value.

Floating-rate preferred shares provide for a dividend that is paid by reference to a market interest rate, such as a percentage of the prime rate. Issues of this type are further subdivided into two classes — those that pay a fixed percentage of the benchmark rate and those for which the fraction varies inversely with the market price of the issue .

Earlier this year, Desjardins Securities introduced another variation — rate-reset preferred shares. The yield is set at a spread above the yield on five-year Canada bonds. That spread will remain throughout the life of the issue. After five years, investors choose between another fixed-rate preferred or a floating-rate preferred. That repricing means the preferred shares will be brought back to trading at par, given that investors are being offered a new “market” rate.

So far, rate reset preferreds have been popular with investors, says Nagel: “They like them because the banks are involved.”

Whatever variation of preferred shares your clients choose, it’s important to stick to high-quality issues, says Michael Sprung, president of Sprung & Co. Investment Counsel Inc. in Toronto.

“Institutional investors limit themselves to buying issues rated Pfd-1 or Pfd-2 by agencies such as the Dominion Bond Rating Service,” he says. “And individuals looking for yield are probably better off with the more stable preferreds offered by banks and insurance companies, which tend to be the largest issuers.”

Adds Hymas: “Preferred share issues come in five grades and each has a high or low designation attached. Investors who are buying only one or two issues should stick to Pfd-1; they can add Pfd-2 when they start to diversify their portfolios.”

Although Hymas hesitates to indulge in market timing, he says that preferred yields are unusually high now and the sector is more attractive than usual.

“Perpetual issues normally trade about 100 to 150 basis points above long-term corporate bonds,” he says. “Right now they’re trading around 250 bps higher. That’s after-tax equivalent income.” IE