RBC Dominion Securities Inc. April 2018 A guide to preferred shares A special report by the Portfolio Advisory Group Written by Christopher Girdler, CFA, Fixed Income Advisor, and the Fixed Income Strategies team 2 | A guide to preferred shares A guide to preferred shares Preferred shares are an integral part of a Canadian’s suite of investable assets that exist in a variety of structures, each with their own features. A commonality across all structures is that preferred shares are perpetual instruments, with interest rate sensitivity dictated by features such as dividend terms, call dates, and reset dates. This guide serves as tool for investors that are new to preferred shares and want to build base knowledge, as well as those who want a refresher on the asset class. Below is a summary of a number of highlights of this report: Common features of preferred shares • Dividends • Structure and call feature • Equity/capital treatment • Where preferred shares sit in the capital structure • Taxes Key market characteristics • Market size • Issuing sectors • Development of structures Analyzing preferred shares • Correlations between preferred shares, bonds, and equities • Historical volatility and returns • What trading prices tell you about the probability that a preferred share will be redeemed • Understanding what different yield measures tell you and when to use each different measure • Key risks to consider • Interest rate risk • Credit risk • Call risk • Extension risk • Liquidity risk • Tax risk Structures of preferred shares • Fixed rate perpetual preferred shares • Rate-reset preferred shares • Floating rate preferred shares • Fixed-floater preferred shares • Split shares • Retractable preferred shares Portfolio considerations • Incorporating preferred shares within a portfolio Appendix • NVCC and what it means to Canadian investors April 2018 | RBC Wealth Management 3 | A guide to preferred shares Preferred shares—The alternative funding vehicle Canadian corporations can choose from a variety of options to raise capital, with common share and debt offerings being two frequently selected. A common share offering provides capital (cash) to the corporation in return for an ownership stake. Investors receive a share of profits and any income that gets paid in the form of dividends. In a debt offering, the corporation borrows capital (cash) and promises to pay it back at a set date in the future. The corporation is required to pay a rate of interest throughout the life of the bond, typically a fixed rate set at the loan’s origination. Preferred shares represent an alternative source of capital for corporations that are typically sold to investors through a public offering in a similar manner to common shares. One of the features that draws investors to this asset class is that any cash flow is taxable as dividend income rather than interest income. Common features of preferred shares Dividends Preferred shares pay a dividend, stated as a percentage of the $25 par value. The terms of the dividend are set when the preferred shares are issued, and the dividend may be a fixed rate or can be linked to a reference rate such as the 5-year Government of Canada (GoC) bond, the 3-month GoC T-bill rate, or, in the case of legacy issues, the corporate prime rate. The dividend may stay fixed or it may move up or down with the prevailing market conditions. The type of dividend depends on the structure of the preferred share which we will explore more of later. Perpetual instruments with call features Preferred shares typically don’t have a maturity date but are callable at Preferred shares can be in set intervals and prices, at the issuers’ discretion. This means preferred existence for as few as five shares can be in existence for as few as five years or into perpetuity. years or into perpetuity. Issuers typically compare the terms a new preferred share would carry to an existing issue when determining whether to redeem an existing issue. Redemptions typically occur when a company can reduce its costs by refinancing at a lower dividend rate. Equity/capital treatment Corporations typically issue preferred shares because they represent a non-dilutive (to common equity holders) form of equity funding. For non-financial corporates, preferred shares are classified as 50% debt and 50% equity on a corporation’s balance sheet. This is an important point because the cost of preferred shares is often closer to debt than it is to equity, making them an efficient financing option. For a financial borrower, the attractiveness of preferred shares is that they count towards important measures of capital which, when divided by their assets (loans), provide an indication of their financial stability. Preferred shares and the capital structure: Between debt and common Preferred shares sit between equity debt and common equity in a Preferred shares sit between debt and common equity in a company’s company’s capital structure. capital structure, as demonstrated in the chart on the following page. This April 2018 | RBC Wealth Management 4 | A guide to preferred shares means that in a case of company liquidation, preferred shareholders rank behind (are subordinated to) bondholders in order of payment, but rank ahead of (senior to) common equity holders. Given this junior ranking, preferred shares are typically issued by more credit-worthy borrowers as there is generally weaker demand for a subordinated claim on a weak or heavily indebted corporation that has limited cash flow to draw on to service preferred share dividends. Preferred shares rank between debt and equity in the capital structure of a Canadian corporate • Senior debtholders have priority claim on non-collateral assets in the Senior event of liquidation. debt • Failure to make a coupon payment in a timely manner means an issuer is in default. • Investors have first priority claim on the firm’s cash flows. Subordinated • Investors are subordinated to senior debtholders meaning they have second priority on cash flows and second claim on assets in the event debt of liquidation. • Cash flows to preferred shareholders are subject to management’s Preferred discretion but are paid ahead of common share dividends. Preferred shares share investors have the next claim on assets after debtholders in the event of liquidation. • Cash flows to common equity holders are subject to management’s Common discretion. equity • Common equity shareholders have a claim on the residual [leftover] assets in the event of liquidation. Source - RBC Dominion Securities, Inc. Preferred shares and the capital structure: Priority of payment versus A common equity dividend common equity dividends cannot be paid while a Another feature that marks the seniority of preferred shares over common preferred dividend is not equity relates to the payment of dividends. A common equity dividend current. cannot be paid while a preferred dividend is not current. On top of this, for non-financial issuers (those that are not banks and insurance companies), dividends on preferred shares are cumulative. This means that if a dividend payment isn’t made during one quarter, it is added to the dividend payment due in the following quarter. As a general rule, the presence of a common equity dividend that has been paid in an uninterrupted fashion for a number of years and is well covered by internally generated cash flow is a positive for preferred shares. This is because the ongoing payment of a common equity dividend ensures the regular stream of preferred share dividends will also be paid. Preferred shares and the capital structure: A less-secure payment stream than a bond Preferred share dividends are not legal obligations, and a company will not fall into default if it misses a dividend payment like it would if it were to miss an interest payment on outstanding debt. Although their market reputation may be brought into question, companies can suspend preferred share and common equity dividends in an effort to save cash to April 2018 | RBC Wealth Management 5 | A guide to preferred shares service debt. A common equity dividend will typically be suspended first before a preferred share dividend is at risk although they may be suspended at the same time if the financial situation weakens materially such that the company is dangerously close to defaulting on its debt. Taxes When compared to debt interest, preferred share dividends represent a more tax efficient source of income for a taxable investor and a less tax efficient outlay for a corporation. This is because Canadian resident investors get tax credits for dividends received from preferred shares, thereby increasing their after-tax value. Bond investors are less fortuitous and pay income tax on each coupon payment received. For a corporation, preferred share dividends are paid out of after-tax earnings whereas interest payments on debt are paid from pre-tax earnings. This makes preferred share dividends a less tax-efficient outlay than interest payments for a corporation with positive earnings. Key market characteristics Preferred share market size: Less than 5% the size of the bond market Preferred share market is less The preferred share market has a market capitalization between $60B and than 5% the size of the bond $65B (as of December 2017). Although this seems large, it is relatively small market. compared to the total fixed income market in Canada. The Canadian bond universe has a market capitalization that exceeds $1.5T (as of December 2017), according to the latest index data (FTSE TMX). Market composition: Issuing sectors The largest issuers of preferred shares have historically been banks and insurance companies. More recently, energy infrastructure companies have become frequent issuers. These three sectors account for over two-thirds of the outstanding preferred shares. Market composition: Issuance structure Rate reset, fixed-to-float and their sister floating issues make up the majority of the current preferred share market, with a smaller portion of the market currently in fixed rate perpetuals.