What are Preferred Shares?
Companies raise capital primarily through common equity offerings (stocks) and debt offerings (bonds). Preferred share offerings, however, provide companies with another source of financing with characteristics of both equity and debt. Similar to stocks, preferred shares represent ownership in a company, with coupons like that of bonds.
Where Do They Rank in a Company’s Capital Structure?
Preferred shares rank senior to common equity but have a lower claim on assets compared to holders of debt. Thus, preferred shareholders receive priority over common shareholders regarding dividend payments, but their dividends are paid after bondholders’ interest and other creditor obligations are met.
While preferred shareholders do not benefit from the same capital appreciation potential as common shareholders, they often enjoy higher yields than bondholders, making them an attractive option for income-oriented investors.
How Are They Structured?
A handful of different types of preferred shares exist in Canada, each with different dividend terms and reset dates that dictate the interest rate sensitivity of the security. The most common are perpetual, rate-reset, and floating-rate preferred shares. The par value for a preferred share is typically $25.
Preferred shares also have redemption clauses that allow the issuer of the preferred shares to pay back the borrowed capital at certain intervals. These redemption clauses vary based on the type of preferred share.
- Perpetual: Perpetual preferred shares pay a fixed dividend rate for as long as they are outstanding. They behave similarly to bonds in that they perform well when interest rates fall due to the yields on comparable new issues being less favourable, with the opposite occurring when rates rise. These typically cannot be redeemed during the first 5-years after issuance. After the first 5-years, the preferred shares can be redeemed at any point with the annual redemption price decreasing each year by $0.25 from $26 to $25.
- Rate-reset: Rate-reset preferred shares pay a fixed dividend for the first 5 years. After 5 years, the issuer can decide whether or not to redeem the entire issue. If the issuer chooses not to redeem the preferred shares, the issue remains outstanding for another 5 years and it cannot be redeemed during the new 5-year period. At each reset date, the investor has the decision to lock in a new fixed-rate dividend or convert to a floating-rate preferred share. The new fixed-rate dividend is typically calculated based on a “reset spread”, which is specified at the original issuance, plus the 5-year Government of Canada bond yield. This provides investors with a degree of optionality to interest rate exposure.
- Floating: Floating rate preferred shares pay a variable-rate dividend that fluctuates with short-term market interest rates. The dividend rates on these preferred shares typically reset every 3 months. The new dividend rate is typically calculated based on the reset spread plus either the prime rate or the 3-month Government of Canada treasury bill rate. Floating-rate preferred shares tend to outperform other types of preferred shares when interest rates rise but underperform when rates fall.
Why Own Preferred Shares?
- Higher Yield: Preferred shares provide income-oriented investors with an alternative to traditional fixed-income securities such as bonds. Many preferred shares currently yield around 6.0% – a notable spread above the 5-year Government of Canada bond yield at 2.68%.
- Tax Efficiency: While the interest received on bonds is fully taxable as income, dividends from Canadian companies receive a dividend tax credit. Since preferred shares pay dividends and not income, they can provide a higher after-tax yield compared to bonds when held in taxable accounts.
- Enhanced Diversification: Investors can stand to benefit from constructing their portfolio with preferred shares as their prices often do not move in lockstep with other asset classes. Preferred share price movements tend to be less volatile than publicly trade stocks, with some preferred shares standing to benefit from rising interest rates, unlike bonds with fixed coupons.
What Are The Risks to Consider?
- Interest Rate Risk: Depending on the type of preferred share, the price may fluctuate according to changes in interest rates.
- Credit Risk: The ability of the issuer to pay future dividends will depend on the overall financial health of the issuer. A deterioration in the financial health of the company would negatively impact the price of preferred shares of that issuer.
- Liquidity Risk: The smaller size of the preferred share market in comparison to both the Canadian equity and bond markets results in fewer market participants and lower trading volume. Prices may trade at discounts or premiums to the fair value of the preferred shares.
How Has the Preferred Share Market Evolved?
The landscape for preferred shares in Canada is changing. One significant development was the introduction of Limited Recourse Capital Notes (LRCNs) in July 2020, which Canadian financial institutions can issue as an alternative form of capital. These notes are tax-deductible for the issuer, offering a more cost-effective way for institutions to raise funds compared to preferred shares – whose dividends are paid out of after-tax corporate income. Non-financial companies have also resorted to similar alternatives known as “hybrids”.
As LRCNs and hybrids gain popularity, they are continuing to replace traditional preferred share issuance, particularly in the financial and energy infrastructure sectors. This shift may influence the supply and demand dynamics for preferred shares and could affect their yields and the overall market for these securities moving forward.
Does Hemisphere use Preferred Shares?
Hemisphere has been an active participant in the preferred share market for over a decade. We closely follow these securities and the ongoing market changes. Preferred shares have been a means of augmenting the fixed-income component of our portfolios while providing more tax-advantaged returns for our clients’ taxable and corporate accounts. While the preferred share market has changed significantly over the past few years, some of these changes have presented unique opportunities to achieve higher yields and favourable risk-adjusted fixed income returns.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Please consult an investment manager prior to making any investment decisions.