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.
