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The prospect of rising bond interest rates combined with a bonus of several percentage points has turned rate-reset preferred shares into glamour stocks.

marchmeena29/iStockPhoto / Getty Images

Prices of rate-reset preferred shares, which pay dividends at a fixed rate until they’re reset every five years, have been soaring. And as interest rates rise, these shares’ payouts will increase as their rates reset – regardless of what their issuers’ common stocks do on the basis of sales or profits.

Rate-reset preferred shares make up three-quarters of the S&P/TSX Preferred Share Index, which has risen by 56 per cent since hitting a low on March 16, 2020. Meanwhile, the S&P/TSX Composite Index has risen by about 62 per cent in the same period. Looking ahead, investors are pushing the prices of rate-reset preferred shares even higher in anticipation of further interest rate increases.

What’s driving the performance of these stocks is their architecture. Every five years, they adjust their payouts to the five-year Government of Canada bond rate plus a hefty bonus of several percentage points. That varies with each issue.

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Thus, a rate-reset preferred share with a typical boost of four percentage points to the recent five-year Government of Canada bond that paid 0.94 per cent on April 26 will have a net return of 4.94 per cent. That’s the rate for five years regardless of how the issuing company does as long as it has the money to pay preferred share dividends.

Those dividends have to be paid before common shareholders get their dividends. To be sure, dividends on rate-reset preferred shares are only paid when the issuing company has the cash. Yet, they get treated like common stock when it comes to taxes, and therefore have the benefit of the dividend tax credit, making them – depending on the holder’s tax bracket – a much more attractive investment than a fully taxed bond

In a sense, rate-reset preferred shares are in recovery. When the Bank of Canada overnight rate, which had been at 1.75 per cent since October, 2018, fell to 0.25 per cent in March, 2020, as the COVID-19 crisis began to grip the Canadian economy, it dragged down all long-term interest rates and, in effect, rate-reset preferred shares.

Now, the tables have turned. The market expects interest rates to rise, although there is disagreement about just when. Nevertheless, the prospect of rising bond interest rates plus a bonus of several percentage points has turned rate-reset preferred shares into glamour stocks.

For example, Manulife Financial Corp.’s 3.80 per cent Series 17, MFC-PR-M-T rate-reset preferred share traded at more than $22.50 for 2018 and much of 2019, then tumbled with falling interest rates below $12.50 in 2020. It has recently traded at $23.10 on the prospect of the rising five-year Government of Canada bond rate plus 2.30 per cent on the payout reset date of December, 2024.

The bad news is that all preferred share dividends come after bondholders and other corporate obligations are paid. Moreover, preferred share issuers can call them – or redeem the stocks – on reset dates rather than pay higher dividends in the ensuing five years.

That risk is evident in the yields of rate-reset preferred shares compared to yields of bonds and stocks. For example, BCE Inc. BCE-T common shares, recently priced at $57.87, pay an annual dividend of $3.50 to yield 6.56 per cent. For preferreds, the BCE 4.26 per cent Series AO preferred share BCE-PR-O-T was recently priced at $24.03 to yield 4.43 per cent. It resets on March 31, 2022. at the Government of Canada five-year bond rate plus 3.09 per cent.

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At the time of writing, the five-year Canada bond pays 0.94 per cent, so if the BCE rate-reset preferred share were reset today, it would pay 4.03 per cent – more than four times the federal bond. Meanwhile, a BCE 7.0 per cent bond was recently priced at $134.34 to yield 3.32 per cent. Clearly, yield rises with risk. But rate-reset preferred shares’ call price restrains how high their prices can go.

In fact, Alfred Lee, portfolio manager and investment strategist at BMO Global Asset Management in Toronto, notes that 65 per cent of preferred shares are called by issuers, which then pay the usual price of $25 a share. If investors bought the share for more than the call price, they risk a loss. If not called, the shares, which are perpetual, can be outstanding for a great many years.

In contrast, if investors bought a preferred share for less than $25, a call at $25 offers a capital gain. But even a small loss is mitigated by the fact that preferred dividends get the dividend tax credit, which makes them more appealing than bond payouts taxed as income. Investors have to balance the tax disadvantage, in the case of bonds, with tax-advantaged preferred share yield.

But there is a catch, says Chris Kresic, head of fixed income and asset allocation for Jarislowsky Fraser Ltd in Toronto.

“When you buy a preferred [share], you are transferring a call option to the issuer. It can take away the upside,” he says. “The investor has to price the call risk. It’s the difference between the current share price and the call price. That’s one potential loss. The other is that preferred shares, which are equity, tend to follow the prices of their issuers’ common shares. If the price of a common share goes down, the preferred share is likely to follow.”

Looking five years ahead, James Orlando, senior economist at Toronto-Dominion Bank, says the five-year Government of Canada bond rate could be 1.95 per cent in 2026. That would make a typical preferred with a base interest of 3 per cent pay 4.95 per cent, a fact that would be noticed by issuers who could call at the usual $25 price, depending on whether they could refinance at lower bond rate interest, which would be tax-deductible as a cost of business to the issuer. Dividends for preferred shares, like common dividends, come out of profits. They are not costs.

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For rate-reset preferred share investors, the advantage of being first in line for dividends ahead of common shares needs to be balanced with the risk of the share being called.

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