Why blue-chip financial firms are sweetening the deal for preferred shares

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Banks and insurers want capital, and they're willing to pay for it.

Manulife Financial Corp. announced on Monday a new preferred-share offering that will yield 4.85 per cent, which is big enough to appeal to everyone from the sophisticated pension fund to the individual retail investor looking for income.

But more important, the yield supports a trend that has seen other Canadian blue-chip financial firms offering similarly generous terms on their preferred shares, shining up this beleaguered asset class.

Preferred shares are a hybrid of stocks and bonds.

Like bonds, they generally have fixed yields for a specified period of time – often five years – but they trade like stocks on exchanges with cumbersome ticker symbols.

In recent years, preferred shares have been hit hard as bond yields have fallen.

That's because the yields on many preferred shares are reset after five years, so big quarterly payouts have been cut down to reflect the lower yields on government bonds.

The moving parts here can be complex because there are many types of preferred shares with different terms.

But the carnage is plain and simple.

The S&P/TSX preferred share index slumped 36 per cent over the three-year period to January, 2016.

Banks, and now insurers, have responded to the sell-off by sweetening their offerings with attractive terms because they rely on preferred shares to boost their capital levels.

That means big yields over the first five years, but also compelling yields when they are reset.

In the case of the new offering from Manulife, the preferred shares will be issued at $25 each and pay a quarterly dividend of 4.85 per cent a year for a five-year period.

After that, the dividend is reset at a rate that is 3.83 percentage points above the five-year Government of Canada bond yield. This implies that investors should do well regardless of whether bond yields rise or fall. The current yield on the five-year government bond is 0.95 per cent.

If the yield fell to just 0.2 per cent in five years, you would still get a payout of more than 4 per cent on your preferred shares.

If bond yields rise, say, say, to 2.2 per cent, the yield on your preferred shares will jump to more than 6 per cent.

Canada's big banks have been issuing similar preferred shares recently, and the response has been ravenous.

In August, Toronto-Dominion Bank raised $1-billion with shares yielding 4.85 per cent.

Earlier in the year, when the sell-off of preferred shares was particularly bleak, Royal Bank of Canada raised $750-million with shares yielding 5.5 per cent.

The downside to these types of preferred shares: The issuers can redeem them after five years, if they wish, which means your money would be returned to you.

As well, nothing is bulletproof.

If banks and insurers sink into deep financial problems, you could lose your money.

Keep in mind, though, that if RBC runs into trouble, the rest of your portfolio would probably get roughed up too.

Sophisticated institutional investors, looking for higher yields than they can get from government bonds, have been eager buyers.

If you're not feeling quite as sophisticated, you can get around the effort involved in tracking down the ticker symbols of preferred shares by buying an exchange-traded fund that holds a basket of different issues.

I own units of the iShares S&P/TSX Canadian preferred share index ETF – I bought after the sell-off, honestly.

The fund has 230 different holdings and has a yield of 4.8 per cent.

John Nagel, formerly a preferred share analyst at Desjardins Securities before retiring earlier this year, prefers an ETF that has managers choosing which shares to buy.

He suggests the Horizons Active Preferred Share ETF.

"This is well managed and doesn't have to automatically respond to rebalancing every quarter, but takes advantage of opportunities as they arise," Mr. Nagel, who is now an independent consultant, said.

Including payouts, the fund has delivered a total return of 5.1 per cent this year, outperforming the preferred share index by one percentage point.

Those are not huge gains – but next to bonds, they look good.