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A benefit of preferred shares – and the funds that hold them – is that the cash flow is taxable as dividend income rather than interest income.Nikada/iStockPhoto / Getty Images

Preferred shares have been neglected in recent months thanks to falling interest rates, which have turned these once sleepy bond alternatives into a volatile asset class.

About 70 per cent of the market for preferred shares today is dominated by the rate-reset preferred, in which the dividend is adjusted every five years to reflect changes in interest rates. Put simply, when interest rates fall, preferred shares suffer, as the recent performance of exchange-traded funds (ETFs) in the space demonstrates.

Horizons Preferred Share ETF (HPR-T) has declined by about 17 per cent during the past 12 months, as of Oct. 21, while BMO Laddered Preferred Share Index ETF (ZPR-T) was down by 16 per cent and iShares S&P/TSX Canadian Preferred Share Index ETF (CPD-T) dropped by 14 per cent.

Toronto-based Evolve Funds Group Inc. launched Evolve Dividend Stability Preferred Share Index ETF (PREF-T) in late September for investors considering tax-loss selling and who still want to remain invested in the asset class through a portfolio of Canadian preferred shares.

Preferred shares, considered a hybrid security with both equity and fixed-income features, are controversial in today’s market, with arguments on both sides as to why financial advisors might want to consider them for clients’ portfolio.

A benefit of preferred shares – and the funds that hold them – is that the cash flow is taxable as dividend income rather than interest income. That’s unlike a bond, for which distributions are taxed as interest income. Preferred shares can also have a yield that’s approximately three times higher than that of investment-grade bonds.

Some believe today’s low valuations could be an attractive entry point for investors who are attracted by the yield preferred shares offer.

Still, advisors should approach the investment with caution, says Brad Goldhar, senior vice-president, senior investment advisor and portfolio manager with the Goldhar Group at BMO Nesbitt Burns Inc. in Toronto.

“The preferred share market has been a bit of a minefield,” Mr. Goldhar says.

Advisors who use preferred shares for clients’ portfolios need to have in-depth knowledge of the asset class, while also ensuring clients are on board with the strategy and understand the risks.

“Not all preferred shares are created equal,” Mr. Goldhar says. “There are different structures. … Whether you are evaluating a fund or an ETF, you should really understand the underlying structure of the types of preferred shares the ETF or fund invests in.”

And while he believes preferred shares can play a role in the fixed-income side of a client’s portfolio, “it can’t be a large component. It can complement other fixed-income investments.”

Mark Yamada, president and chief executive of Toronto-based Pur Investing Inc., is skeptical of preferred shares as an investment option, believing a total return approach that combines capital gains with dividend and interest income often yields better results – with less volatility.

“Preferred shares are complicated, with different provisions and embedded options,” he says.

Although preferred shares do have tax benefits, Mr. Yamada likens preferred share investors to die-hard Toronto Maple Leafs fans. “Focusing on after-tax returns is fine as long as you don’t care about growing capital. Leafs fans may like when their team scores goals, but they are destined to lose the overall game,” he says.

Thus, to invest in preferred shares, “you have to be a real believer,” Mr. Yamada says. “The question is, what are you believing in?”

For those committed to preferred shares, Mr. Yamada believes ETFs are the best way to invest in the asset class and says “an active approach is better than a passive one because the market is relatively illiquid.”

Ryan Domsy, vice-president and portfolio manager, fixed-income, at Foyston, Gordon & Payne Inc. in Toronto sees preferred shares as a largely misunderstood asset class.

“People are focused on the short-term loss … and not the true attribute of preferred shares, which is long-term cash generation,” says Mr. Domsy, who subadvises Evolve Active Canadian Preferred Share Fund (DIVS-T).

He says most companies that issue preferred shares have strong credit profiles and continue to pay out dividends over time. “When you buy a preferred share [fund], you should expect to hold it for a long period of time and not trade in and out to time market swings.”

Mr. Domsy says advisors should consider preferred shares for clients looking for cash generation or overall yield in their portfolios.

“[These are] clients who need to earn income on their investments,” he says.

Mr. Domsy also believes it could be a good time to buy into the asset class because of the recent correction. Furthermore, he points to the rebound in preferred shares after the last correction, in 2015-16.

“This is an excessively attractive time, in which the yield advantage versus other fixed-income asset classes is much higher than it usually is,” he says. “It’s always quite high relative to other fixed-income securities, but in this environment, it’s even higher – and that’s a time people should overweight to preferred shares or introduce them into their investment portfolios.”

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