A Primer on Canadian Preferred Shares
March 3, 2017
CLICK HERE TO DOWNLOAD
What are preferred shares?
Preferred shares are hybrid securities – they have characteristics of both equities and fixed income. Like equities, preferred shares in Canada trade on an exchange, pay out distributions in the form of dividends, and appear on the equity side of the balance sheet. However, like bonds, preferreds also have a par value, generally pay fixed distributions, and generally have no shareholders voting rights.
Ranking in the Capital Structure
Because preferred shares possess characteristics of both bonds and equities, they sit between the two in a company’s capital structure. Thus, in the case of a bankruptcy, they rank above common equity in a claim for distributions and the right to liquidation proceeds, but below all other classes of fixed income.
Types of Preferred Securities
The Canadian preferred share market is relatively small, representing about $66.2 billion in assets, but its popularity has been growing as of late, as yield-hungry investors seek out alternative sources of income and institutional investors continue a rotation out of bonds and into preferreds that started in early 2016.
1. Perpetual preferred shares
Perpetual shares, like the name suggests, are perpetual in nature – they don’t have a maturity date. These shares can often be held for decades and because of their long duration, they tend to be sensitive to interest rates and credit spreads and a fixed dividend.
2. Rate-reset preferred shares
Rate resets currently represent the majority of the preferred securities market (see Exhibit 2 for market share breakdown). These shares pay a fixed dividend rate until a specified date. Assuming the security is not recalled by the issuer, the holder of the security can either lock in a new dividend rate (typically determined based on a spread above a similar-term Government of Canada bond), or can exchange the shares for a floating rate preferred issue.
Rate-reset and floating rate preferred shares are generally the most attractive in a rising rate environment, as they tend to be the least sensitive to interest rates.
There are three subsets of rate resets:
- Minimum dividend rate resets – when reset, the dividend cannot be lower than the initial rate.
- Non-Viability Contingent Capital (NVCC1) rate resets – conversion of these into common shares is enforceable by the regulator under pre-determined circumstances.
- Non-NVCC bank rate resets – not convertible into common shares, and under Basel III, after 2022, will no longer qualify as Tier 1 Capital
3. Floating rate preferred shares
Floating rate preferreds pay a regular dividend that moves in tandem with a reference rate (usually the prime rate). Given the environment of ultra-low interest rates in recent years, some issuers have implemented a minimum dividend amount (generally referred to as a “floor”).
This sector also includes fixed floating rate preferred shares, which pay a fixed dividend until the reset or call date, then can either (i) lock in a new fixed dividend, set by the issuer, until the next reset date, or (ii) be exchanged for a floating rate preferred.
4. Retractable/convertible preferred shares
Retractables are issues that can, depending on the prospectus, be redeemed or converted to common shares by the holder at par value on a specified date.
Unlike bonds, a preferred share issuer is not legally obligated to pay distributions. For this reason, investors should pay close attention to the ratings provided by Standard & Poor’s (S&P) and/or Dominion Bond Rating Service (DBRS). These credit ratings agencies rank the creditworthiness of preferred securities (Exhibit 3).
Why Invest in Preferred Shares?
There are many advantages to adding Canadian preferred shares to a portfolio.
- Stable source of income
As they rank above equities in the capital structure, preferred shares take priority over common equities in terms of dividend payments and safety of principal. An issuer may cut or suspend dividend payment for common shareholders, but still, pay dividends to preferred shareholders. And should an issuer miss dividend payments, the amount accrues to the preferred shareholder and must be paid out before any distributions are reinstated on common shares.
- Tax-advantaged distributions
In Canada, preferred shares’ distributions are treated as dividends for tax purposes. Dividends are more advantageous from a tax perspective than interest income received from bond distributions – particularly for Canadian investors in the highest marginal tax brackets.
Preferred shares can also provide diversification benefits, as correlations to bonds and equities is historically low.
- May have lower interest rate risk than bonds
Like bonds, preferred shares are generally sensitive to interest rates, with prices falling when rates rise, and rising when rates fall. However, different types of preferred shares have different sensitivities to interest rates, depending on their structure (Exhibit 6). Because their dividends reset or directly track a reference rate, rate reset and floating rate preferred shares tend to be less exposed to interest-rate risk.
While preferred shares have many advantages, they are not without risk. The following is a list of the most prevalent:
- Credit Risk
Credit risk encompasses both the risk of default (i.e., the issuer will stop paying the dividend) and the risk of recovery (i.e., how much of the security’s par value – generally $25 – that would be recoverable in the event of a default). Investors should always keep an eye on their preferred shares’ creditworthiness, via S&P or DBRS ratings. Again, the different types of preferreds have different sensitivities (Exhibit 7).
- Market Risk
Preferred share prices can decline along with common equities during periods of market volatility.
- Call/extension Risk
Preferred shares often have a feature that allows the issuer to redeem – or “call” – an issue when it’s in the issuer’s best interest to do so, such as when a particular issue has a high dividend rate. Factors that can also influence the decision to call the securities include market conditions, and regulatory changes. Alternatively, issuers often have the ability to keep the security in the market past the call date.
- Liquidity Risk
Investors of preferred shares should also be mindful of liquidity risk, as a lack of buyers in the market can and ask price of the security; typically, the wider the spread, the less liquid – and riskier – the security.
For these reasons, we believe it prudent to use an actively managed fund to invest in preferred shares.
Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.