Preferred shares (preferreds) have many of the same characteristics as common stocks and bonds. Preferreds also have some distinct qualities which set them apart from other investments.
Why invest in preferred shares?
- Can provide a source of stable income when bond yields are low. Dividend rates are set when the shares are issued and take priority over common stock dividends.
- Often offer a higher yield compared with bonds of the same issuer.
- May qualify for favourable tax treatment. Income from Canadian dividends is eligible for the federal dividend tax credit.
- Can help diversify a portfolio. Preferreds tend to have low correlation with Canadian stocks and bonds. This means they may react differently to changing market conditions.
Preferred shares are like a cross between common shares and bonds – with important differences
| Preferred Shares | Equities | Bonds | |
|---|---|---|---|
| Ownership in company | Yes | Yes | No |
| Voting rights | No | Generally yes | No |
| Payouts |
|
|
|
| Credit rating | Yes (distinct from bonds) | No | Yes |
Preferred share correlation to other asset classes
|
Correlation |
|
|
Canadian Bonds |
-0.09 |
|
Canadian Equities |
0.65 |
|
U.S. Equities |
0.42 |
|
Developed Markets ex North American Equities |
0.49 |
|
Emerging Market Equities |
0.42 |
Source: Morningstar, Bloomberg, RBC GAM. 5 year correlation. As of December 31, 2021. Correlation of daily returns relative to the S&P/TSX Preferred Share Index. All in CAD. Canadian Bonds: FTSE Canada Universe Bond Index, Canadian Equities: S&P/TSX Composite Total Return Index, US Equities: S&P 500 Total Return Index (CAD), Developed Markets ex. North America: MSCI EAFE Net Return Index (CAD), Emerging Market Equities: MSCI Emerging Markets Net Return Index (CAD).
Are preferred share dividends protected?
Yes, there are two important layers of protection:
- Preferred share dividends are “protected by” common share dividends. A common share dividend cannot be paid while a preferred dividend is outstanding. This is important because dividends on preferred shares are cumulative, except in the financial sector. If a dividend isn’t paid out in one quarter, it is added to the dividend payment due in the next quarter – and the entire dividend amount owed on the preferred shares must be paid before common share dividends may be issued.
- If a company declares bankruptcy, its bondholders would be paid out first, followed by preferred shareholders, then common stock shareholders.
Rate-resets
- Shares are issued with a dividend at a set spread to an interest-rate benchmark. The spread reflects credit risk, often correlated with high yield credit spreads. The benchmark is generally the Government of Canada five-year rate.
- Dividend is fixed at this rate for five years, then resets to the new prevailing five-year rate.
- Issuers may either call or extend the preferreds at each five-year mark. Issuers often call back preferred shares when they’re able to finance at cheaper rates.
- Shareholders may convert rate-reset preferreds into floating-rate preferreds at each reset date.
Perpetuals
- Shares have no set maturity date. They pay a fixed dividend indefinitely.
- Shareholders have no option to put the issue back to the issuer (not retractable).
- Issuer may call or extend the preferreds based on predetermined dates and prices.
- Dividends tend to be more sensitive to credit spreads and interest rates, like long-duration bonds.
Floating rate
- Pay a dividend that “floats” alongside a reference rate (generally the Bank of Canada prime rate for Canadian preferreds).
- Do not allow shareholders to put the issue back to the issuer (not retractable)
Retractables
- Shares pay a fixed dividend in perpetuity, similar to perpetual preferreds.
- Issuers may call back the preferreds, but shareholders can also put them back to the issuer (retract) at a set par value on the specific date(s).
As of December 31, 2021 Canada’s preferred share market had a market capitalization of $76.2 billion. More than 80% of the preferred shares market is in rate-reset notes with perpetual shares making up another 17%.
Types of preferred shares in the Canadian market
Source: RBC GAM, Blackrock. Data as of December 31, 2021. As reflected by the S&P/TSX Canadian Preferred Share Index.
Preferred share ETFs can be an efficient way to invest in a diversified basket of preferred stocks. Diversification can reduce risk when you invest and lead to a smoother investment experience as markets change.
You can access actively managed ETFs where the fund investment team does the homework for you to select the underlying stocks. This analysis includes fundamental analysis, credit research and interest rate sensitivity analysis.
Or, you can choose an index-tracking ETF that simply follows an index of preferred share ETFs.
Investing in preferred shares could help diversify your portfolio. Talk to your advisor to learn more about diversifying with ETFs.
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