The venerable Sir John Templeton once advised investors to buy stocks at the moment of maximum pessimism. We're more or less at that point in the preferred share market right now, so get moving.
The stock markets in general have been cranky lately, but preferred shares are in a class of their own. Considering how dull they normally are, the current slump is almost shocking. In fact, let's call it a bear market for preferreds.
"The market peaked at the end of March, 2007, and since then we've had the worst peak-to-trough performance that I have on record - that's about 14 or 15 years," said James Hymas, president of Hymas Investment Management and one of a small group of preferred share experts in this country. "Right now, we're a whisker above that trough. If somebody sneezes, we may hit a new trough."
Preferred shares issued by the big banks and blue-chip companies such as Brookfield Asset Management, George Weston and E-L Financial have fallen in price in recent months and now offer dividend yields solidly above 5 per cent and sometimes more than 6 per cent. Thanks to the dividend tax credit, that's like making 6 to 8 per cent or more from an interest-paying bond or guaranteed investment certificate, depending on your tax bracket and province.
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As for safety, preferred shares offer a higher level of security than common shares. Only after the common share dividend has been suspended would preferred dividends be at risk.
Mr. Hymas gauges the yield on preferred shares by comparing them to a 30-year Government of Canada bond. In recent days, the spread between these bonds and preferred share yields has been in the range of 3.7 percentage points, if you measure on an after-tax basis that addresses the different treatment of dividends and interest.
A spread of 1.5 percentage points suggests preferreds are no bargain, while 2.5 points is neutral. At 3.5 points, you've really got something. You won't hear Mr. Hymas say so directly because he refuses to make a call on the market. But he does go so far as to offer this bit of wisdom: "Preferred shares are more attractive now than they usually are."
This is where the maximum pessimism comes in. The reason why preferred yields are so appealing right now is that prices have been beaten down (prices and yields move inversely). Preferreds are typically redeemable by the issuer at a price of $25, but you can buy them today for several dollars less per share in many cases. This means there's total-return potential in preferreds today - you get quarterly dividends, plus the hope of a capital gain at some future date.
Preferred shares are like bonds in that they lose value when rates rise, as they did last year. Bad corporate news also hurt preferreds in 2007. The big banks are major preferred share issuers, and they're out of favour right now because of concerns about their exposure to the U.S. subprime mortgage crisis. George Weston preferreds have been dragged down by the problems at its Loblaw supermarket subsidiary.
Mr. Hymas said these problems emerged after a flood of new preferred shares were issued in the spring of 2007. "I suspect a lot of those new issues found their way into the hands of people who didn't know what they were buying. Two months later, they found their shares had gone down."
What ensued was a wave of selling in preferreds that continued right through the end of last year as a result of tax-loss selling. In mid-January, the preferred share market was rocked anew when Bank of Nova Scotia announced a new issue set to yield 5.6 per cent. This is considered a premium yield and it caused the price of existing preferreds to fall (and their yields to rise). Mr. Hymas said banks were issuing preferreds a year ago at 4.5 per cent.
Looking for ideas in the preferred market? How about Canadian Imperial Bank of Commerce, which is the big bank hit hardest by subprime exposure, as well as the other big banks? There are several different CIBC preferred issues with yields these days in the mid-5-per-cent range, which compares with posted five-year GIC rates of 3 per cent at CIBC branches.
"The banks are the bluest of the blue chips, even CIBC," Mr. Hymas said. "CIBC has been hit hard lately, but on a global basis they're still extremely strong."
There are several issues of Brookfield preferreds trading these days with yields of 5 to 6 per cent and higher. The shares have a rating of pfd-2 (low) from credit rating agency DBRS, which means they're investment grade, or solid enough for pension funds and insurance companies to hold.
Another option is to buy funds that hold a diversified basket of preferred shares. An exchange-traded fund called the Claymore Cdn S&P/TSX Preferred Share ETF (CPD-TSX) is one example.
If you buy preferred shares now, you have to be prepared for further price declines. The correct response if this happens? "You ignore it," Mr. Hymas said. "You're buying these shares for the income stream."
Today, preferred share income streams are on sale at steeply discounted prices that suggest bear market conditions. You know what Sir John Templeton would say about that.
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Preferred picks
BROOKFIELD ASSET MANAGEMENT
(BAM.PR-N-TSX)
These shares have a dividend yield of more than 6 per cent, which is sky high for a company of Brookfield's calibre. What's the deal? One explanation is that Brookfield has saturated the market with too many preferred share issues, while another is that the company suffers from a "conglomerate discount," which means it's penalized for having a variety of interests (infrastructure, real estate) rather than a single focus.
Yesterday's close $18.08., up 8¢
CANADIAN IMPERIAL BANK OF COMMERCE
(CM.PR.I-TSX)
With these shares, you get an extra half a percentage point in dividend yield over CIBC common shares, plus additional peace of mind. In desperate times, common share dividends would get the axe before preferred share dividends. Like all the shares listed here, these preferred shares are perpetuals, which means they have no set redemption date.
Yesterday's close $20.57, down 2¢
POWER FINANCIAL CORP.
(PWF.PR.H-TSX)
This blue-chip holding company's interests include names like Great-West Lifeco, Canada Life and mutual fund giant IGM Financial, so you know the underpinnings are strong. A further sign of strength is the very solid pfd-1 (low) rating from credit rating agency DBRS. And yet, the dividend yield is in the mid 5-per-cent range these days. Go figure.
Yesterday's close $25.05, up 18¢
