If cash is the forgotten asset class then preferred shares are an unknown asset class to many.
Investors sometimes think of preferred shares as a variation on common shares or stock. While common shares represent ownership in a company, preferred shares do not. In fact, preferred shares are more like the distant cousin of bonds, rather than common shares, and they pay a dividend, usually on a quarterly basis.
Part of the confusion surrounding preferred shares is in the name because both preferred shares and common shares are called shares. The other similarity comes in the form of distributions made.
Preferred shares pay dividends and the distributions made to common shareholders are also dividends. However, preferred shares are a contractual obligation made by the company issuing them. While companies have one series of common shares (in rare cases, two series), there can be several different series of preferred shares issued by the same company. The terms of the contractual obligation will differ from one series of preferred shares to another and these terms can include the term maturity of the preferred share, the dividend rate, a dividend adjustment provision, a share buyback provision and so on.
These contractual obligations of a preferred share very closely resemble the contractual obligations of a bond. Unlike common shares where dividends are declared and paid at the discretion of the board of directors, the dividends of preferred shares are a contractual obligation. In other words, while the board of directors of a company can choose to reduce or suspend the dividend of their common shares, they must pay the dividend of a preferred share.
One of the main differences between a preferred share and a bond is in the form of the distribution.
The former pays a dividend and the latter pays interest. Dividends are paid after the company has paid tax on its earnings and interest is paid before the company pays tax on its earnings. It is an important differentiation because, in an effort to avoid double taxation on the same earnings, dividends are taxed at a lower rate in taxable investment accounts.
There is no advantage to dividends over interest in tax sheltered accounts such as RRSPs and TFSAs.
It is also important to note that only dividends of Canadian companies receive preferential tax treatment in Canada. Dividends of US companies and other international companies are taxed at the same level as interest.
Another important difference is the safety of investments. In the event of a company bankruptcy the assets can be sold to pay the obligations.
Standing at the front of the line are the bankers who have loaned money to the company; next in line are the bond holders, followed by the preferred shareholders. If there is any money left over once these contractual obligations are satisfied, it will be divided among the common shareholders.
The term ‘contractual obligation’ appears again. There is an obligation to repay the preferred shareholders, but there is no obligation to repay the common shareholders. If they want to participate in the potential growth of the company where bond holders and preferred shareholders do not, then they must stand at the back of the line when things go wrong. The common shareholders take more risk for the potential reward.
Since preferred shares do not represent any ownership in the company, they do not benefit as the company grows in value, nor do they typically suffer to the same extent if the company falls in value. As such, the opportunity for capital gain or loss is more limited with preferred shares than common shares. In a word, they are less volatile.
Because preferred shares pay dividends rather than interest and because they are at a different level in the hierarchy of the corporate structure of a company, they deserve to be in their own asset class.
Compared to the world equity markets and the bond markets, the preferred share market is tiny . . . miniscule, in fact. But that doesn’t mean it isn’t an important asset class and it shouldn’t be overlooked. Preferred shares are particularly relevant in taxable investment accounts where the dividend tax credit provides an advantage for dividends over interest.
You can use the tax calculator on MoneyPages (http://moneypages.ca/calculator/32/2017-income-tax-calculator) to illustrate the impact of dividends. Enter a hypothetical income scenario with a significant portion of that income derived from interest and none from dividends. Then, using the same income, replace the interest income with dividend income.
Amazingly in some lower income situations, adding dividend interest can reduce your taxes even if your income increases because of those dividends.
Preferred shares have a lot of characteristics that make them similar to bonds. Where bonds have a contractual obligation to pay interest, preferred shares have a contractual obligation to pay a dividend. The dividend policy on common shares is at the discretion of the company and they can remain the same, be increased, decreased or eliminated at any time.
When selecting preferred shares for a portfolio, the analysis can be very similar to analyzing a bond investment. The quality of the issuer, the dividend yield and other factors must all be considered.
Some preferred shares have a maturity date, some have fixed dividends, some have floating rate dividends, some are known as perpetual preferreds with redemption features and some are re-set preferreds where the dividend yield can be adjusted on a specific date.
All of these features can be intimidating for the novice investor.
However, for those who are willing to do a little extra work, the rewards can be significant. A good financial advisor can help investors walk through the myriad of features that may or may not make a specific preferred share a sound investment at any point in time.
In spite of those challenges, it is not an asset class that should be overlooked, but careful selection of the individual securities is essential.
Diversification by investment features, by issuer, by industry and so on, are important considerations.
Preferred shares often react to interest rate changes in a similar manner to bonds, depending on some of the unique features the preferred share may have. And like bonds, the credit quality of preferred shares can vary.
Because preferred shares may not be easily accessible to some investors, this asset class is sometimes included within the fixed income asset class. Using that approach, there would be five asset classes to consider for inclusion in a portfolio.
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