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A worker walks inside a hot air balloon, as it is prepared for flight, at the International Balloon Fiesta near Bristol in western England August 8, 2008. REUTERS/Alessia Pierdomenico (BRITAIN) (ALESSIA PIERDOMENICO)

Portfolio Strategy

Rising inflation set to shake up sleepy preferreds Add to ...

There's bad news for all investors who held preferred shares through the past two years of turbulence and are looking ahead to calmer times.

Higher interest rates are coming, and that means more upset for preferred shares. Plan now and avoid any unpleasantness to come.

Preferred shares are a more conservative version of the common shares that most people think of when the stock market comes to mind. Preferred shares fluctuate somewhat less in price and are primarily owned by people who want a reliable flow of dividend income.

There are several different types of preferreds, but we'll focus for the most part here on the two biggest. One is perpetuals, which have no fixed date for redemption and never have their dividend reset. They're almost like dividend-paying bonds that go on and on without maturing.

The other type is the fixed reset rate preferred, which has become very popular in the past couple of years because it offers a degree of protection against rising interest rates. Every five years, the issuer must decide whether to redeem them or reset the dividend so that the shares yield a pre-set premium over the five-year Government of Canada bond yield.

Perpetuals are the clear yield leaders. Take Power Financial Series L preferreds, for example. They were priced late this week around $21.50, which produces a yield of around 5.9 per cent based on an annual dividend of $1.28.

Fixed reset preferred shares are far less attractive now on a yield-producing basis, although you might not realize this if you looked at their current yield, or the yield based on current price and dividend.

To get a true yield for fixed resets, you have to factor in the very real possibility that they will be called, or redeemed, by the issuer at its next opportunity. This is an important consideration because many rate reset preferred shares currently trade at higher prices than when they were issued. At redemption, shareholders will only get the issue price, usually $25.

It's not certain that fixed reset preferreds will be redeemed in the next several years, but if they are it could mean a capital loss for shareholders. Factor that into the yield and you get something like 3.42 per cent for Royal Bank of Canada's Series AV rate reset preferreds.

Note the higher risk level if you like the superior yield from perpetuals. "They are the most interest-rate sensitive," said Tara Quinn of Scotia Capital's portfolio advisory group. "They are going to be extremely volatile with rising interest rates."

So perpetual preferred shares fall in price as rates rise. Will it be as bad as 2008, when these shares as a group fell sharply? Ms. Quinn doesn't think so, but she's still wary.

"I wouldn't be looking at perpetuals moving into a rising rate environment," she said. "I like the rate reset structure."

Ms. Quinn acknowledges that the yields on fixed reset preferreds are low, but on an after-tax basis they are equivalent to a bonus of about 2 percentage points over what you can get from corporate bonds. Of course, this only applies to non-registered accounts, where you can take advantage of the dividend tax credit.

Warning: Fixed reset preferreds could lose some value if rates rise. "They are going to fluctuate with rising interest rates, but there will be nowhere near the same impact as a perpetual," Ms. Quinn said.

A different take on the appeal of perpetual and fixed reset preferreds is offered by James Hymas, president of Hymas Investment Management. He doesn't believe perpetuals will fall in price as much as some people expect and, regardless, he still sees some benefits in them for investors who want income.

His argument begins with the point that there are two issues to consider when choosing income-producing investments - the safety level of the investment itself and the reliability of the income it produces.

Fixed resets do a good job of protecting investors when inflation's on the rise and pushing up interest rates, Mr. Hymas. But they fall behind perpetuals when it comes to preserving a reliable flow of income. Let's say you bought some fixed reset preferreds back in early 2009, when they were being issued with yields of 6 per cent or more. Those shares could be very well be redeemed in a few years, leaving you in the tough position of trying to replace a 6-per-cent yield.

With perpetuals, your income flow lasts indefinitely, if not in perpetuity, and it's comparatively safe.

"If you've got something from one of the big banks paying $1 a year, you can be as sure as you can be of anything in the investing world that you're going to get that $1 a year until the shares are called," Mr. Hymas said.

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