Although preferred shares are not widely popular, a few advisors and portfolio managers use them extensively for their tax-efficient properties. They offer nominal yields similar to bonds of the same quality but they qualify for the dividend tax credit, resulting in more after-tax income in the hands of the investor. And the recent increase in federal and provincial dividend tax credits has further enhanced the returns of preferreds.

At Toronto-based Goodman Private Wealth Management, many advisors recommend 10% of clients’ portfolios be in preferred shares. But it’s not easy to find other advi-sors who are as enthusiastic.

The same applies in the fund world. Five dividend fund families — GGOF Monthly Income, Sentry Select Dividend, CI Signature Dividend, SunWise CI Dividend and Millennia III Canadian Dividend — have 30%-50% of their assets in preferreds, according to Morningstar Canada data as of Nov. 30, 2006. Desjardins Dividend Fund has about 18%, AGF Canadian Conservative Income Fund has 13%, QFM Structured Yield Fund has 12% and HSBC Dividend Fund has 10%. But the vast majority of both equity and fixed-income funds hold no preferreds at all.

The question is: are Goodman and these managers are on to something others have missed and you should be considering preferreds for your clients?

For many advisors and money managers, preferred shares fall into a no man’s land between bonds and equity. They are riskier than bonds because they come second to bonds in terms of distributions in the case of bankruptcy. But, although they are senior to common shares in this respect, they don’t participate in the company’s capital appreciation and dividend increases as common shares do.

The lower interest rate environment also makes them less attractive than they once were, says Dom Grestoni, head of North American equities at I.G. Investment Man-agement Inc. in Winnipeg. In-vestors Dividend Fund, which Grestoni manages, had about 50% of its assets in preferreds 15 years ago but now has less than 6%. He doesn’t see that changing unless there is a significant hike in interest rates and/or a lot more companies start issuing preferreds. A U.S, dollar crisis, for example, could push rates up 200 basis points or so and provide selective opportunities to pick up preferreds at attractive prices.

Grestoni prefers common shares because inves-tors can benefit from dividend increases as well as capital appreciation.

But Gordon Higgins, portfolio manager at Sentry Select Capital Corp. in Toronto, says preferreds can play an important role in dividend and balanced funds. He notes that a 4.5% yield on a preferred share becomes 6.6% after taxes because of the dividend tax credit. “It’s hard to get 6.6% in interest-bearing securities,” he notes.

Put another way, the tax in Ontario on preferred dividends is 25%, while interest is taxed at 46%, says Patrick Roy, senior portfolio manager for alternative equities and trading strategies at Fiera YMG Capital Inc. in Montreal and manager of Millennia III Canadian Dividend Fund.

The dividend tax credit increase may enhance the popularity of preferreds, says Higgins. But make sure you are getting preferred shares, he adds, not just preferred securities issued by split-share closed-end trusts. Only true preferred shares qualify for the dividend tax credit.

Roy notes that most issuers of preferreds are quality companies with little credit risk. Preferreds are predominantly issued by financial institutions but utilities also have them. In fact, BCE Inc. and Bell Canada account for 10% of the total Canadian preferred marketplace.

Preferreds are rated by agencies such Dominion Bond Rating Service Ltd. in Toronto and New York-based Standard and Poor’s Corp. and Moody’s Investors Service Inc. P1 and P2 ratings are equivalent to investment-grade bonds and have little risk of default. With P3 ratings, an understanding of the company and its prospects is needed because risk of a downgrade is high, says Higgins. He doesn’t recommend P4s, because investors may not get the dividend and the capital is at risk.

Another advantage to preferreds is their low commissions, Higgins adds. Investors can buy 100 preferred shares at a reasonable price; they often have to fork out $25,000-$50,000 or more to get a fair price on bonds, he says.

As well as ranking behind bonds in the case of bankruptcy and not participating in the upside as common shares do, another disadvantage to preferreds is their small market — just $33 billion, according to Roy, with institutions buying much of that.

@page_break@Nevertheless, Higgins says, there is still a lot of choice even if you stick, as he does, to highly rated preferreds. Higgins’ funds currently have holdings in more 100 preferreds issued by more than 40 companies.

Roy is even more adamant about the advantages of preferreds. “Investors should question why they have only bonds,” he says, adding that 50% of fixed-income in preferreds would not be unreasonable if investors kept to high-quality issuers.

There are various types of preferreds, but the two main choices are perpetuals and floating-rate preferreds. There used to be a lot of convertibles, which could be converted into cash or common shares at specified dates; today, conversion would be into cash. In any event, there are few convertible issues any more.

Perpetual preferreds account for most of the market. They are issued at a set interest rate and have no maturity date, but issuers have the option of calling an issue, then re-issuing at a lower rate.

Issuers like them because they don’t have to re-issue periodically, which is costly, but still have the option of re-issuing if it is to their advantage. For banks, there’s the added advantage that preferreds qualify as Tier I capital.

Floating-rate preferreds have a maturity date and pay a dividend that is tied to the interest rate. Issuers benefit when rates go down; shareholders benefit when rates move up. Floating-rate issues are good to buy if there is a probability that interest rates will rise, but they are also good for matching liabilities. For investors with monthly payments tied to interest rates, for example, floating-rate preferreds that yield the amount of those payments would make a lot of sense.

Although floating-rate preferreds are a smaller part of the market, there are more than 20 highly rated issues, including some by Alcan Inc., BCE and Power Corp.

There are also hybrid preferreds, referred to as “fixed floating-rate” preferreds. These allow shareholders to choose whether to receive a fixed or a floating-rate dividend. They include reset dates every five years, at which time shareholders can change the type of dividend they receive.

Higgins recommends a diversified portfolio of preferreds, including some older perpetuals that pay higher interest rates and, therefore, won’t be called if rates rise. Floating-rate preferreds can be added if they suit the client’s portfolio. IE