Preferred Shares

Preferred shares or commonly known as “preferreds” are equity securities that share common characteristics with debt instruments such as bonds. They are often referred to as a hybrid security since they share common characteristics with both equity and debt instruments. In conjunction with equity securities, preferred shares represent an ownership interest in the company, they generally do not have maturity values, pay dividends instead of interest, and are recognized on the equity portion of a company’s balance sheet. Similar to debt, preferred shares typically have no voting rights, have a par value, and pay a fixed distribution rate that is determined at the issuance of the preferred share. Preferred shares also share commonality in regards to debt with both of them having seniority over common shares in the capital structure hierarchy. In the case of a liquidation or bankruptcy proceedings, preferred shares will have greater rights over a company’s assets than common shares, but will have less rights than debt holders of the company.

The main types of preferred shares are:

- Perpetuals: perpetual preferred shares have no maturity date and pay a fixed dividend for the duration of its issue. Due to unknown duration, these types of preferred shares are very susceptible to interest rates and credit spread risk. Typically, when interest rates go up, the price of the preferred goes down, and vice versa. As treasury yields rise to the level of preferred share yields, demand for the stock can go down causing the price to go down. These types of shares can also be redeemed by the issuer, but the holder has no retraction rights. - Rate Reset (5 years): These types of preferred shares experience a dividend rate reset at a specified reset date. Upon the reset date, the holder has the option to lock in a new fixed dividend rate reflecting the current rate environment or to exchange the issue for a floating rate preferred share. The new rate is usually a couple basis points over a Government of Canada bond with a similar term. - Floating Rate: a floating preferred share pays a quarterly dividend to shareholders. The dividend rate “floats” in relation to a reference rate which is typically the prime rate.

Now that we have covered the definition and commonalities preferred shares have with equity and debt instruments, we must now ask ourselves why should invest in preferred shares?

- Asset Class Diversification: preferred shares’ unique hybrid characteristics allow it to have a low correlation to both stocks and bonds. By adding preferred shares to your portfolio, it will act as another asset class providing a diversified return from stocks and bonds. - Tax Efficiency: Bonds and preferred shares are similar in the way that they both offer distributions as a percentage of a par value. However, bond distributions, commonly known as interest, are taxed as interest income. Preferred share distributions, known as dividends, are taxed as dividends which have preferential tax treatment to interest income. - Predetermined Dividend Rate: preferred shares offer income security by having a predetermined dividend at the rate of issuance. Unlike common shares, which can experience a change in dividend rate at any time, preferred share dividends are fixed and must be paid. Some preferred shares have a cumulative provision where any omitted dividends must be paid out to preferred shareholders before common shareholders. In addition, if the company also decided to not pay a dividend for the quarter, dividends will be in arrears for preferred shareholders. - Lower volatility: Since preferred shares are protected from wild market swings due to their lower correlation to the market, preferred shares tend to trade around their par value under normal market conditions. This lower volatility gives preferred shares an advantage over stocks stability wise and allows investors to have exposure to the markets as a lower volatility alternative compared to most common stocks while maintaining a higher yield than most fixed income securities.

Pros of Preferred stock:

- Higher yield than most fixed income securities and common stocks - Lower volatility than common stocks - Corporate structure hierarchy over common stocks - Greater liquidity than corporate investment grade bonds

Cons of Preferred Stock:

- Interest rate sensitivity of perpetual and floating rate bonds - No voting rights - No exposure to price appreciation of the underlying security - Some preferred stocks can be redeemed by the company at any time - Perpetual bonds lack of maturity date results in uncertainty of retrieval of invested principal