If you’re looking for a steady stream of income with the potential of a little extra upside, investing in preferred shares may just be the way to go.
These types of shares rank higher in a corporate structure than common shares, which means they have priority over common shares when it comes to payment of dividends or if a company goes out of business.
But even though that red carpet treatment is what most people know about preferred shares, financial experts say there’s a lot more to them than a spot near the front of the line.
“If investors can find the good, high-quality preferred shares, they’re a really good fit for someone who has some non-registered money, who’s looking for a relatively stable stream of income,” said Brett Strano, a financial adviser with Edward Jones in Mississauga, Ont.
“Because of the tax credits on the dividends from Canadian corporations, they can actually retain a little more after-tax money than they could otherwise get just from a fixed income security.”
Tax benefits aside, one of the biggest upsides of preferred shares is that they can provide not only fixed income, but also some certainty as to when their holders will get paid.
But investors should make sure they pick high-quality stock, since there are different types of preferred shares and, just like fixed-income securities, they have a credit rating attached to them.
Banks and utilities companies, for example, tend to be rated a bit higher than some smaller companies, which may not be as actively traded.
“All the big blue chip companies in Canada tend to have a higher than average credit ratings, but when you get into some preferred shares of companies that don’t have that credit rating, investors have to know that the dividends can be reduced or even eliminated at any time,” Strano said.
Some also have call dates, just like bonds do, so that investors can expect a timely repayment of their principle, while others are in perpetuity, which means a holder may not know when he or she will get the money.
Perpetual preferred shares are also more sensitive to interest rate changes, which tend to move in the opposite direction of the market value of preferred shares.
Tom Hamza, president of the Investor Education Fund, said that while preferred shares offer a middle ground between bonds and more volatile, lower-yield investments, people need to understand how they function and that they may be affected by interest rate changes.
“There are other real reasons why many people don’t have them in their portfolio. . . . They’re not as common as common shares — things like liquidity are important for some people and there isn’t a great deal of liquidity in most of them,” Hamza said.
“Certainly my impression is that there’s a lot of people who ignore them, simply because they’re complicated and in some ways different from everything else in their portfolio because they take almost a hybrid position.”
Experts agree that risk isn’t something many investors are comfortable with after the 2008 downturn, but many also say that if investors limit individual stocks to no more than five per cent of their portfolio they can reap some rewards.
“As long as investors can go through and do their homework and select the right one, they do have an appropriate place in some people’s portfolios, in the appropriate amount,” Strano said.
“It really depends what the investor’s tolerance is for risk,” he said. “Preferred shares tend to be a little bit more risky ... so we want to make sure that investors have a relatively moderate tolerance for risk.”
A financial adviser would also want to make sure there’s not too much overlap with other investments in the portfolio, and that buyers understand that preferred shares tend to act and trade more like a fixed income security than like the underlying common shares of the same company, he added.
“Typically, the reason an investor will take these kinds of investments is for the income that they produce, so you shouldn’t be too worried about the market value of them, but you have to be aware that that risk does exist,” Strano said.
James Hymas, president of Hymas Investment Management in Toronto, said preferred shares, which have taken a hit as investors speculate about what the U.S. Federal Reserve will do about its tapering program, are currently more attractive relative to bonds than they have been since the credit crunch.
“I believe that people will be nibbling away at the preferred shares market,” Hymas said. “No taxable investor should own more than a bare minimum of long-term corporate bonds because preferred shares are much more attractive than long-term corporate bonds at this point.”
So do your homework, decide how much you’re willing to risk and speak with a financial adviser to see if the upside of investing in preferred shares outweighs the negatives for you.