What, exactly, is preferred about preferred shares?
Repeated thrashings are what you get when you own them. The latest example: A year-to-date decline of about 16.5 per cent for the S&P/TSX Preferred Share Index, including share price changes and dividends.
Canada’s preferred share market is valued at about $60-billion, much of it held by retail investors. They’ll continue to receive reliable dividend income if they hold on, with tax advantages in non-registered accounts thanks to the dividend tax credit. But jagged price moves have made for an utterly gross ownership experience with preferreds over the years. You have to ask yourself, do you really need this aggravation in your life?
There is some credence to the term “preferred share.” Prefs get their name from the fact that they have priority over common shares in a case where a struggling company is having difficulty paying dividends. This explains why preferred shares were once seen as a safer, more stable sibling to the common shares that we typically think of when investing.
But as with so much in investing, preferred shares have become more complex and volatile. Prefs have had some nice moments over the years, yet the S&P/TSX Preferred Share Index produced an average annual total return of 1.1 per cent for the decade to Sept. 30. The S&P/TSX Composite Index made 7.3 per cent over that period.
The preferred share index had a wonderful year in 2021, rising 19.4 per cent on a total return basis. But then, what didn’t do well in 2021? The biggest investing story of that year might have been the rocket-like trajectory of GameStop GME-N, a retailer of videogames that generated this headline on a 2020 Business Insider story: “The world’s biggest video game retailer, GameStop, is dying: Here’s what led to the retail giant’s slow demise.”
The preferred shares debacle this year can be explained away in similar fashion – everything is in retreat as a result of inflation and rising interest rates. But preferred shares have had more than their fair share of misfortune in the past decade, and they fell more than Canadian common shares and bonds in the first nine months of this year.
The most recent pullback in preferreds is a perfect example of how they so often disappoint. About 60 per cent of the pref market is made up of rate reset shares, which have their dividend reset every five years to maintain a preset yield premium over five-year Government of Canada bonds. The rising rate trend this year should be helpful to rate resets, but the pref market is tanking.
One explanation is that preferred shares are caught up in the investor rush out of investments that are sensitive to changes in interest rates. Bonds are in this group, and so are utility companies such as Fortis Inc. FTS-T and Emera Inc. EMA-T.
If that’s the case for preferred shares, then it’s certainly possible that a rebound takes shape when rates plateau and then move lower. But, as ever with prefs, there are further complications.
A contributing factor in the bullish feeling toward these shares in 2021 and early this year was a move by the big banks to stop issuing prefs and instead raise funds using a type of security called a Limited Recourse Capital Note. LRCNs, available directly to institutional investors only, are more tax-efficient for the issuer.
Prefs benefited from a scarcity narrative based on the rise of LRCNs. As banks issued more of these securities, they would call in preferred shares for redemption. A shrinking market should in theory support prices, but two big banks recently passed on an opportunity to redeem a rate reset preferred issue.
The volatility of preferred shares has no easy fix, especially given the rise of exchange-traded funds that hold these securities. With their strong diversification, preferred share ETFs are actually a smart solution for investors who want to hold these securities and are put off by the phenomenal difficulty of selecting individual issues.
But these ETFs can add to selling pressures when preferred shares are out of favour. There’s selling of preferred shares by individual investors, and then by the ETFs as well. Three preferred share ETFs made the list of Top 20 funds, with the biggest outflows of money in the first nine months of the year.
Owning a stock of any type that pays a dividend is a two-part experience. There’s the flow of dividend income, and the ups and downs of the share price. With common shares, you accept some degree of risk that your dividends could be cut while also recognizing that there could be significant capital gains.
With preferred shares, dividend predictability is paramount. A lack of capital gains potential would be an acceptable price to pay for this benefit, but what prefs have actually delivered is capital pain. A $10,000 investment in the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD-T) five years ago would be worth $9,838 as of mid-October, with reinvested dividends included.
Prefs have paid their dividends, and you should continue to expect that if you stick to blue chip issuers. But the price moves have made owning prefs a consistently painful experience. How much can you stand?