Preferred shares make a worthy contribution to a diversified portfolio of income-bearing assets, with features that place them between a dividend-paying stock and a bond.

“Preferred shares are a great place to be in this era of low interest rates,” says Barnaby Ross, vice president at RBC Dominion Securities in Toronto. “They should be a part of everybody’s portfolio.”

Preferred shares offer tax-efficient returns that generously surpass those offered by bonds, common stocks and traditional interest-paying alternatives. For example, Power Financial Corp.’s first preferred shares series H recently traded with a yield of 5.5%, and RBC non-cumulative first preferred shares series AC recent traded with a yield of 4.4%.

Unlike bonds that pay interest, the yield on preferreds is boosted outside of registered plans by tax credits. For example, a preferred share may have a dividend yield of 4.5%, but with the help of dividend tax credits for investors in the top tax bracket in Ontario, this yield is equivalent on an after-tax basis to a bond that pays 6.3% in interest. (The yield advantage can vary depending on the province of residence and the tax bracket of the investor.)

The primary attraction of preferred shares is their healthy dividend; however, preferred shares also get priority over common shareholders when it comes to payment of dividends and they have a prior claim on assets if the company goes out of business. However, preferred shareholders are paid only after bondholders and other creditors are paid.

Usually, preferred share dividends are “cumulative,” which means if the company misses any dividend payments, preferred dividend payments that are in arrears must be paid before common share dividends.

“Non-cumulative” preferred shares do not have to make up for missed dividends, although the dividends payable on the same issuer’s common shares usually cannot be paid if preferred share dividends have stopped.

The downside of preferreds is that unlike common shares, they don’t allow shareholders a say in corporate governance through voting rights attached to the stock. Nor do they usually participate in the growth of a company by increasing the dividend as profit grows, and consequently, there is less opportunity for capital gain on preferred shares.

They are typically issued at a face value of $25, $50 or $100, with a fixed dividend payment for the life of the share, usually paid quarterly. Because the dividend is fixed, they react much the same way as bonds to any changes in market interest rates. They could drop in value if interest rates rise, and may increase if rates fall.

Some are “floating rate” preferreds, where the dividend is adjusted according to changes in interest rates, but these typically trade at a premium to regular preferreds and therefore offer less yield.

Some preferred shares come with an expiration date, allowing them to be redeemed at the option of the shareholder or retracted by the issuing company. Even “perpetual” or “straight” preferreds – those without maturity dates – can usually be “called” at certain dates at the discretion of the company, and during times of dropping interest rates, they could be replaced by preferreds with lower dividends.

In contrast, federal government or provincial bonds may carry a lower yield, but there is no danger of it being called away.

Because of the possibility of a preferred share being called, James Hymas, president of Toronto-based Hymas Investment Management Inc., says it is important for investors to calculate the prospective yields to the first possible call date, or “yield to worst.” If the security is trading at more than par value, investors should make sure they will be paid enough in dividends before the first possible call date to compensate for the premium being paid.

“Yield to worst is the single most important measure when buying a preferred,” says Hymas, who manages Malachite Aggressive Preferred Fund, an investment fund available to accredited investors, and also offers analysis of individual preferreds at his website

Advisors can help clients assemble their own mix of preferreds, or they can choose from a handful of preferred share funds. Ross likes actively managed Omega Preferred Equity Fund, a mutual fund sponsored by the National Bank of Canada. Many diversified income funds also have significant holdings in preferred shares.

Exchange traded fund (ETF) offerings include BMO S&P/TSX Laddered Preferred Share Index ETF (TSX:ZPR) and iShares S&P/TSX Canadian Preferred Share Index Fund (TSX:CPD).

Assets in Canadian preferred share ETFs have grown dramatically in recent years. They currently stand at $1.9 billion, compared to a mere $45 million in 2007.

This is the second article in a three-part series on the quest for income. Next: generating income with ETFs.