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portfolio strategy

Negotiating the preferred-share maze Add to ...

Investment opportunities that were previously just a faint hope have emerged in the bond market decline this summer.

Example: A 5-per-cent yield from preferred shares, which are a more conservative cousin of the common shares that dominate stock market investing. Preferred share prices were hit hard along with bonds this summer, and that means higher yields from the dividends they pay. In the past week or so, those yields got interesting enough to generate some buying.

“A lot of it is retail, but now institutions are coming in because they want to buy stuff that is yielding over 5 per cent,” said John Nagel, a vice-president and preferred share specialist at Desjardins Capital Markets. “Three months ago, it was hard to find anything with a 5-per-cent yield and a good credit rating.”

If you’re discouraged by low returns from bonds and term deposits, a 5-per-cent yield from preferred shares may sound hard to pass up. Be careful what you buy in the preferred share market, though. Some shares can be counted on to deliver a long-term flow of high-yielding dividend income, and others may end up giving you a lower dividend in the near to medium term.

Preferred shares are part of a group of investments that are highly sensitive to interest-rate increases, such as we’ve seen lately (utility stocks and real estate investment trusts are also in the club). Though up smartly in recent days, the S&P/TSX Preferred Share Index had still lost 6.4 per cent over the year through midweek. That’s a big move for a type of security that people own to provide drama-free dividend income.

There are a few different types of preferred shares, with the highest yielding being the straight preferred, or perpetual. This type of share offers no fixed maturity date, and that makes them the most sensitive to changes in interest rates. Some quick examples of straight preferreds that have taken a price hit: Canadian Utilities Series AA (CU.PR.D) and Great-West Lifeco Series H (GWO.PR.H) have both fallen in the 14-to-15-per-cent range this year and now yield about 5.5 per cent.

That’s better than double the yield on a 10-year Government of Canada bond on a before-tax basis. After taxes, in a non-registered account, the yield available from perpetuals looks even better as a result of the dividend tax credit. But if you buy now, or you’re looking at your existing holdings, you must be prepared for more price volatility ahead when interest rates rise further.

Let’s be clear about the price risk on preferreds. While not as volatile as common shares to scary plunges, preferreds can still fluctuate a fair bit. Also, preferred shares are thinly traded. Spiky price moves are not uncommon when only a small number of shares are being bought and sold.

And yet, falling prices are just a distraction if you own pref shares for the right reason, which is generating dividend income. A company in financial stress must cut dividends on common shares before touching preferred share dividends – that’s one layer of protection for investors who own pref shares. Another is that most issuers of preferred shares are blue-chip companies with strong financials. Bottom line: If you like the income flow, keep the shares and ignore what’s happening to the price.

The highest-profile type of preferred share is the rate reset, which pays a dividend set to yield a premium over the return of a five-year Government of Canada bond. Every five years, the issuers of these shares either redeem them at a preset price, typically $25, or reset the dividend to reflect bond yields of the moment. Shareholders may also get the option to switch into a floating-rate preferred share, where returns are pegged to a benchmark interest rate and will move both up and down over time.

Mr. Nagel said investors expected rate resets to be redeemed on the fifth-anniversary dates that have started to crop up in 2013 (these shares started to gain popularity in 2008, when many of them offered especially juicy returns).

But recently, several of this kind of pref issued by Bank of Montreal, Bank of Nova Scotia and Toronto-Dominion Bank were instead reset. Disappointed investors have been selling rate resets as a result. Are they now an attractive buy like perpetuals?

Maybe not. It’s considered a virtue in preferred share investing to have a redemption date you can count on. Think of owning a bond – the price may fluctuate, but you gain confidence from knowing you’ll get your initial investment back on maturity. Some of these bank-issued rate resets will be redeemed in the year ahead, but it’s now clear that this isn’t a sure thing.

Another issue is that the price of some rate resets is currently above the redemption price. Buy now and you could take a capital loss on your shares if they’re redeemed.

Finally, there’s the fact that having your shares reset will almost certainly reduce their yield. While five-year Canada bond yields have moved a lot higher recently, they’re still significantly lower than they were when many of today’s rate resets were issued five years ago.

How much lower could the yield on rate reset shares get? In a recent report, CIBC World Markets said the shares most likely to be reset have premiums of 2.5 percentage points or less. CIBC said that with a five-year Canada bond yield at today’s level of 1.8 per cent, yields on these same shares would fall to an average 3.6 per cent on reset. Compare that with the current yield on big bank resets, for example, which are now in the 4-to-6-per-cent range.

On their reset date, most rate reset shares offer a chance to convert into a floating rate preferred share. The benefit of doing this is that floating rate shares hold up well at a time of raising rates, unlike perpetuals. But there’s a cost.

CIBC says floating dividend rates are typically equal to the yield on 90-day Treasury bills plus a premium. With these T-bills yielding just 1 per cent, the dividends paid by a floating rate share will produce a lower yield than a rate reset or perpetual. If T-bill rates rise a lot, you could end up doing well with floating rates. But for the time being, they’ll pay less.

If you like the idea of having some preferred shares that can stand up to rising interest rates, then consider the floating-rate preferred shares already trading. Mr. Nagel said floating-rate shares account for less than 4 per cent of the entire preferred market, so there’s not a huge selection to choose from. Those that are available offer current yields ranging from the 2.1 per cent of Power Financial’s A series (PWF.PR.A) to BCE’s Series AB (BCE.PR.B) at 3.2 per cent.

Final note: The best source of details on particular preferred share issues are the investor relations area of company websites and the website prefinfo.com.

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

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