No wonder investors are confused by preferred shares.
On the one hand, they offer attractive yields, and their dividends are safer than those of common shares because preferred shareholders get priority. If a company gets into trouble, it will cut its common dividend before it can touch its preferred payout.
On the other hand, preferred shares can be complex animals, with features such as call privileges, retraction options and, in a more recent wrinkle, yields that reset periodically based on a spread over five-year government bond yields.
Here to lend his expertise is James Hymas, president of Hymas Investment Management in Toronto. He writes the PrefLetter and manages the Malachite Aggressive Preferred Fund.
Mr. Hymas sees some attractive values in preferred share land, but says investors need to tread carefully.
Who should invest in preferred shares and why?
The class of investor who can most use them are people who are approaching or getting into retirement, and these people - assuming they're healthy and so on - they're looking at 30 years of income that they need and a discount preferred share is more likely than most instruments to provide a good level of income for that entire time. Bonds mature, and aren't as tax effective of course [because Canadian preferred dividends qualify for the dividend tax credit]
Should preferreds be counted as part of the equity portion of a portfolio, or the fixed- income portion?
I count them as part of fixed income, on the grounds that they have first-loss protection and they have a defined yield. Very bad things have to happen to the common shareholders before the preferred shareholders get hurt.
What weighting do you recommend?
I always recommend that the preferred share component be less than half of the fixed-income portfolio. I would say between 20 per cent and 50 per cent of the fixed-income complement for somebody who has long-term income needs.
What sort of yields are available?
Right now straight perpetuals are yielding more than 200 basis points [two percentage points]over long corporate bonds on a pretax equivalent basis. That is a very substantial spread. The long-term average is in the range of 100-150 basis points, so they are a better deal than they usually are.
What do you mean by "pretax equivalent" basis?
Long corporate bonds now are paying about 5.8 per cent. Investment grade straight preferreds are also yielding about 5.8 per cent, on average. But taking into account the dividend tax credit, you would have to make more than 8 per cent on a corporate bond to get the same after-tax return in a non-registered account.
These perpetual preferreds could be called or bought back, though, correct?
Most straight perpetuals are trading fairly well below their issue price. While perpetuals can be called, given current market prices if they're called they'll be doing so at a premium to the current price.
What if interest rates rise? Won't that be bad for preferreds?
When anybody starts talking about interest rates, you always have to ask, which interest rates? Government rates are very different from corporate rates, and long rates are very different from short rates. They're subject to different influences and move in different cycles.
So, while I will agree with the consensus that government rates, particularly at the short end, are almost certainly going to rise over the next two years, perhaps substantially at the very short end, it's not so clear what's going to happen to corporate rates. During the credit crunch, government yields plunged, as we know, going down to derisory levels for T-bills. Corporate rates actually rose. So when we talk about interest rates rising you're actually really just talking about the short-term government rates, and if things get back to normal then corporate rates should actually decline somewhat.
If long corporate rates do increase, perhaps in response to galloping inflation, then yes, preferred share prices will decline.
What about these newfangled "rate-reset" preferreds? These are the ones where the yield resets after a certain number of years at a spread over five-year government bonds - unless they're called, of course.
This has proved to be an incredibly popular product amongst retail investors. Retail is generally deathly scared of inflation, and they are prepared to pay quite a substantial yield differential in order to get some inflation protection.
I should point out that these fixed-resets are currently paying in the area of 3.5 per cent now. That's a yield to call [the yield the investor would get if the issue is called at the first reset date] Given the current environment they are extremely likely to be called, because the reset spread stated at the time of issue is now far in excess of what the issuers need to pay currently.
Sounds like you're not a big fan.
One reason why this structure became popular with issuers is because they can call them at par after only five years. Normally the perpetuals are only callable after five years at a premium and they only become callable at par in nine years. These rate-reset issues are callable at par sooner and that is not good.
In other words, the issuer holds all the cards?
That is the problem, yes. This structure broke new ground in terms of giving power to the issuer.
For investors who aren't comfortable buying individual preferred shares, is Claymore's preferred share exchange-traded fund (CPD-T) a reasonable option?
It has been reasonable but it is getting less so. It is based on the S&P/TSX Preferred Share Index and the credit quality of that index has been declining substantially since inception. There is now a significant holding in PFD-3 issues, which are on the cusp of investment grade. If this recession drags on for as long as some people fear, then we might get a few of these lower quality issuers going to the wall.
During the financial crisis, we saw Citigroup suspend preferred dividends. How safe are the preferred dividends of Canadian banks?
The banks are in far better shape in Canada than virtually anywhere else. In Canada I suggest the chances of a big bank defaulting on its preferreds are so small that they're not measurable.
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Glossary
Straight perpetual
Pays a fixed dividend for the life of the security (until it is called by the company).
Callable
The issuer has the right, but not the obligation, to redeem the security at a stated time and price. All preferreds are callable.
Retractable
The investor has the right, but not the obligation, to force the company to buy back the shares at a stated time and price.
Fixed-reset or rate-reset
The dividend is adjusted after a specified number of years to a stated spread over the five-year government bond yield, unless the issue is called.
John Heinzl