Despite all the talk of rising interest rates, investors remain as keen as ever to find higher yielding alternatives to bonds.
One alternative that keeps coming up is preferred shares. “Is it okay to hold preferred shares instead of bonds and GICs?” a reader asked recently by e-mail.
Allow me to present five numbers that support a “no” answer to this question. Each represents an annual loss for the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD-T), which can be used as a proxy for owning a well-diversified portfolio of preferred shares.
- minus 17.2 per cent: That’s how much this ETF fell in 2008, as the global financial crisis raged;
- minus 3 per cent: CPD posted this loss in 2013;
- minus 15.3 per cent: CPD fell this much in 2015;
- minus 8.4 per cent: This was the loss for CPD in 2018;
- minus 22.8 per cent: The loss in the first quarter of 2020, when the pandemic arrived (CPD later rebounded that year).
Way back, preferred shares were described as stocks for widows and orphans because they provided a secure dividend income. This aspect of preferreds remains true. Companies only cut preferred share dividends after they have stopped paying quarterly cash to holders of common shares. It’s a sign of deep distress to cut the preferred share dividend, so it’s rarely done.
In no way is the income from preferred shares as secure as bond income. But the risk of default with preferreds from blue-chip issuers is pretty remote. Where preferreds fall way behind bonds is in adding stability to portfolios in bear markets for stocks and economic shocks.
The 2008 and first-quarter 2020 losses for CPD document how preferred shares tend to get flushed by investors in chaotic markets. Money goes to bonds for safety, not preferred shares.
Preferreds also suffer when the economic outlook turns sour and there are expectations for falling interest rates. Most preferred shares these days are a variety that resets the dividend rate every five years to reflect changes in interest rates. These preferreds work well when rates are expected to rise, but they tend to sell off when the rate outlook takes a turn for the worse.
On the basis of investment income flows alone, preferred shares beat bonds. But if you hold bonds to stabilize your portfolio in tough times, bonds are preferred over preferreds.
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