Preferred shares are the Cinderellas of the stock market. Subordinated debt sold as equity, they are little known and not often traded by the institutions that control the bulk of trading activity on the Toronto Stock Exchange. And although preferreds offer higher yields than those of their issuers’ bonds, their performance has been downright sluggish. Yet, dowdy preferreds could become the belle of the ball this year.
Last year was a pretty dull one for preferreds. In 2011, the broad DEX universe bond index, which tracks all Canadian bonds, was up by 9.7%. Corporate bonds within the DEX rose by 8.2%. Yet, preferreds were up by just 5.8%.
“Their recent performance,” says Randy LeClair, managing director and fixed-income strategist with Manulife Asset Management Ltd. in Toronto, “is reason that there should be a catch-up by preferreds this year.”
LeClair, portfolio manager of Manulife Preferred Income Fund, says the logic of going to preferreds is in the pickup in yield for retail investors – and preferreds are a retail product. For instance, five-year guaranteed investment certificates pay an average of 2.3% a year, whereas preferreds typically offer yields of 2.75%-4.0% a year.
But preferreds are not GICs; preferreds are not eligible for insurance from the Canadian Deposit Insurance Corp. Furthermore, preferreds are not bonds, which are contractual obligations of borrowers to pay interest and repay principal. In fact, preferreds stand below conventional bonds for payment in insolvencies (but ahead of common shares).
Still, preferreds must receive dividends before any dividends can be paid on common shares, which is substantial protection. And, given that most preferreds are issued by banks, insurers, pipelines and utilities with credit ratings of A or better, preferreds are almost all investment-grade, says Kent Wideman, chief credit officer with DBRS Ltd. in Toronto.
Preferreds have a distinctive appeal for clients who want calm portfolios; that’s because preferreds don’t have the volatility of common shares. The frenzy and despair characteristics of common-stock investing are usually absent in the preferreds market.
“Preferreds live outside of the world of common-stock agony,” says James Hymas, president of Hymas Investment Management Inc. in Toronto. His Malachite Aggressive Preferred Fund returned an average 12.3% a year compounded annually for the 10 years ended Feb. 29. His benchmark, the BMO Capital Markets 50 index, produced just a 4.4% return over the same period. An active trader, Hymas turns over the Malachite fund’s portfolio as much as 10 times a year, trading along the yield curve to juggle return and time.
Time is, in fact, the problem for preferreds. Most are perpetuals, which have no windup or date for the refund of principal. In theory, that means your client could be hung out to dry if interest rates rise substantially. But issuers of preferreds often put a “rate reset” feature into the shares so that every five years, they adjust their payouts to give a hefty premium over the five-year Government of Canada bond rate.
For example, Manulife preferred Series D shares pay $1.65 a year. Recently priced at $26.41, that’s a running yield of 6.2%. The rate resets to 456 basis points over the rate on the five-year Canada on June 19, 2014 – at which time it can be redeemed at $25 by the issuer. Redemption is very likely, Hymas says. At the current price, the yield to call is 3.93%. That is the dividend, net of the capital loss difference between present price and redemption price.
This is bond-style analysis – and it is the way preferreds, which work like bonds, have to be examined. Much like bonds, preferreds need to have sufficient income support for their dividends to be paid. Beyond that, corporate earnings are not important, save for the small category of convertible preferreds that can morph into common stock.
The bottom line, of course, is: what does your client get for his or her money? Beste Alpargun, a portfolio manager with Seamark Asset Management Ltd. in Halifax, buys preferreds for the mutual funds she manages. She notes that you can buy an Enbridge 5.16% bond due Dec. 4, 2017, recently priced to yield 2.3%; Enbridge common stock, with a 3% yield; or a preferred share from Enbridge (symbol: Enb.Pr.B.), a 4% issue that resets at 240 bps over the five-year Canada in June 2017.
This preferred’s recent price was $25.70 – and that’s a 3.89% yield to reset. The preferred wins on a straight yield basis, but there are differences: Enbridge’s bond is rated single-A, while the preferred issue is P-2 (low); the bond refunds its principal in five years, while the preferred is a perpetual – although it has a call date.
In a market in which government bond yields are close to historical lows and investment-grade corporate bonds are not much better, preferreds’ large yield pickup is clear. Moreover, the tax credit that turns $1 of dividend into $1.40 of equivalent interest is the gilding on the asset.
None of that is a fairy tale.
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