Preferred share prices have been hit, but remember that they provide you with a dividend before you go dumping them all.Getty Images/iStockphoto
One of the more shocking investing stories of this year has to be the carnage in the preferred share market.
Some preferreds were hammered during that brief hiccup in the summer of 2013 when interest rates appeared to be set for a sustained rise, and others have been brutal in early 2015, as interest rates slide. Investors who own preferred shares have to be reeling at this point. Will these popular bond alternatives ever find favour again?
It does a disservice to preferred shares to lump them into one big category because there are actually some sub-categories that behave differently. Perpetual preferreds are very much like bonds without a firm maturity date, and they're most vulnerable to rising rates. Rate reset preferreds are designed to protect investors against rising interest rates; in a falling rate environment, they're dead weight in the eyes of some investors.
In fact, it's rate resets that are producing particularly bad results for investors right now. The S&P/TSX preferred share index was down 4.9 per cent for the year through Feb. 3, while the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR-T), an ETF that holds rate reset preferreds, fell 7.6 per cent.
Analyst Harry Levant of IncomeResearch.ca explains that rate resets typically have their dividend rate reset every five years to produce a yield that offers a pre-set spread over the five-year Government of Canada bond. Mr. Levant said in a recent note to clients that the spread over the five-year Canada bond was set at 4 percentage points back when rate resets first appeared, but then declined to less than 2 per cent. With five-year Canada bond yields in the 0.6 per cent range, that makes for a disappointing return. Hence the selling of rate reset preferreds right now.
Mr. Levant has been advising clients to minimize exposure to rate reset preferreds on the expectation that rates were not going to rise. His recommended list of preferreds emphasizes perpetuals, though he's looking for developing values in the rate reset category. It's worth noting that ZPR's yield has reached 4.7 per cent. In a non-registered account, that yield looks even better on an after-tax basis thanks to the dividend tax credit.
If nothing else, the recent decline in preferred shares is a reminder to investors that these securities are a questionable substitute for bonds in the portfolios of conservative, risk-averse investors. Preferred shares were pounded in the 2008-2009 crash, manhandled in the rate run-up in 2013 and now they're being kicked yet again. You hold bonds to get away from that kind of thing.
At the same time, investors have to recognize that these declines in preferred share prices have little to do with the dividend payments they make every quarter. We would need far worse economic conditions than we have today for preferred share dividends to be at risk. Remember that if you're tempted to dump your preferred shares right now. The dividends look stable if you own shares issued by blue-chip companies, even while their share prices are under attack.
Rob Carrick