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Preferred shares offer lush yields for those who do their homework Add to ...

With yields often in excess of 5 per cent, preferred shares are extremely attractive in this low yield environment. Unfortunately, investing in preferred shares can be bit like trying to find diamonds in a minefield.

Preferred shares have no voting rights and do not participate in a company’s growth. Their attraction is the relatively high yields they pay (generally higher than common shares) and their favourable tax treatment (which is just like common shares).

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The drawback is their complexity. The Royal Bank of Canada, for instance, has 16 preferred issues, each with a different dividend rate, redemption schedule and market value. Choosing the best requires some sophisticated software.

Investors also have to understand the nature of the preferred share market – an area where misconceptions abound. Many people, for instance, believe that preferred shares should move in line with bond prices. When the U.S. Federal Reserve started musing this past summer about tapering its bond purchases, the bond market sold off sharply on the expectation that yields were headed up. (Bond prices and yields move in opposite directions.)

Unfortunately, many articles in the media suggested preferred share prices should follow suit. Some retail investors panicked and sold their preferred shares.

Sadly, history suggests that those sales were ill-advised, because preferred share yields are remarkably uncorrelated to bond yields. We have analyzed yields over the last decade and the correlation between bond and preferred share yields is actually slightly negative. In other words, preferred share yields have a slight tendency to go down when bond yields rise.

The lack of correlation between bonds and preferred yields reflects the absence of any tight linkage between the two markets. Very few investors trade back and forth between preferred shares and bonds, so there is little impetus for preferred share yields to track bond movements.

This undercuts one of the selling points of so-called floating-rate preferred shares. These are preferred shares in which the dividend rate “floats” in line with some short-term rate, such as that on three-month Treasury bills.

Floating-rate preferred shares supposedly offer protection from higher bond yields, but at a high cost, given the lack of correlation between the two assets. At the present, floating rate yields are substantially lower than fixed-rate alternatives and are unlikely to rise in the next year or two as the Bank of Canada maintains its stimulative monetary policy. The lost income is unlikely to ever be made up.

Floating rate preferreds also face increased pressure from the growth of what are known as rate-reset issues. These preferred shares features a dividend rate that adjusts every five years. Investors typically have the option of hanging on at the new dividend rate or choosing a floating-rate option. About half of investors are choosing the floating-rate option, which is substantially increasing the supply of floating-rate shares and is likely to drive down their prices in future.

Rate-resets have other dangers as well. When they were originally sold, one of the key attractions was the notion that the resetting of the dividend rate would keep their value at or close to $25 a share. But many investors didn’t realize they were giving the issuers an important option – on the reset date, the issuer could adjust the dividend rate or simply redeem the shares for cash.

Now that many rate-reset issues are reaching their reset date, investors are learning that only those issues with low reset yields are being extended, while the ones with higher potential yields are being redeemed.

So what is the best way for investors to navigate the minefield and still get the benefits of preferred share investments?

If you’re a do-it-yourself investor, there are a number of exchange traded funds (ETF’s) that specialize in preferred shares and can provide broad exposure to the sector for a very small fee. The downside is that these ETFs hold lots of low yielding issues that drag down their performance.

Actively managed funds can be more nimble. Their selectivity comes at additional cost. But if you work through a fee-only adviser or one who bills based upon assets under management, you can now find actively managed Class F funds that charge fees close to those of ETFs. So you can enjoy the benefits of preferred shares and leave the minefield to others.

Jeff Herold is the lead fixed income manager at J. Zechner Associates Inc. He began investing in preferred shares 30 years ago and currently manages them for pension and endowment funds as well as the NexGen Canadian Preferred Share Fund.

 

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