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Preferred Shares Remain An Attractive Long-Term Investment

01/04/2016 03:06 EST | Updated 01/04/2017 05:12 EST
Sabine Scheckel via Getty Images
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2015 was definitively a tough year for financial markets, particularly for Canada.

What began as a somewhat promising year ended up being characterized by a plunge in commodities prices, particularly oil, and a corresponding plunge in the Canadian dollar. Heading into 2016, this has generated renewed uncertainty about the direction of the economy -- especially as the U.S. Federal Reserve starts raising interest rates south of the border.

Adding fuel to the proverbial fire has been recent volatility not only in the stock market but also in the bond market, particularly among debt issued by companies. Thanks to uncertainty about the direction of interest rates as well as the prospects for growth going forward, prices for so-called junk bonds and other forms of debt have plunged and yields have spiked.

One area of the markets that has taken a particular beating is the preferred share market, which has witnessed 20 per cent or greater declines this past year. Many Canadians are not familiar with preferred shares and how they work.

Preferred shares are a form of debt disguised as pseudo-equity. They do not represent ownership in a company; they are merely a form of borrowing that pays dividends instead of interest and, unlike bonds, they do not have a set redemption date. In the event a company goes bankrupt, preferred shareholders rank ahead of common shareholders, but behind debt holders.

There are three basic types of preferred shares: perpetual preferred shares (which remain outstanding in perpetuity unless the issuer calls them in); floating rate preferred shares (whose dividends fluctuate with either the prime rate or bond interest rates); and rate-reset preferred shares (whose dividend rates are reset every five years, with dividend resets tied to five-year Government of Canada bond rates).

Preferred shares are fairly popular in the Canadian market due to their high yields, low correlation to bonds and their favourable tax treatment. They can be a great addition to any portfolio as a diversification tool, or as an intricate part of a long-term investing plan. Perpetual preferred shares are the original type of preferred share and have been around almost forever, but due to the fact that interest rates have declined and the dividends they pay out have remained constant, their share prices have acted fairly well over the past few years.

Not so for floating rate and rate-reset preferreds. These securities were issued in the last five or six years to investors expecting that interest rates would eventually go up, helping them benefit from the impact of higher rates down the road.

The issue that generated so many headlines -- not to mention negative returns -- in 2015 was the fact that the opposite occurred. Interest rates in Canada declined, and the values of rate-reset preferreds (based on five-year government bond yields) and floating rate preferreds (based on either 90-day treasury bill rates or some variation of the prime rate) plunged as dividends were reset at lower rates, reflecting current interest rate levels.

However -- and this is where we see opportunity -- rates should at some point rise, allowing these other two types of preferred shares to perform well.

Indeed, from our vantage point, we see the preferred share shakeout as a great buying opportunity, particularly among rate-reset preferreds -- especially those that have a rate reset of at least two years into the future -- as their plunge in prices has made their yields attractive and there is significant potential for capital gains if and when Canadian interest rates do begin to rise.

To be sure, they are not without risk. There is a chance a still-weak economy could spur the Bank of Canada to push rates even lower in the short term, further compromising the value of rate-reset and floating-rate preferreds.

There are additional risks to consider as well. While holders of preferred shares have a higher claim on a company's assets than those holding ordinary shares, they still take a back seat to bond holders in the event something bad happens to the company and it can't meet its financial obligations.

Still, for some income investors looking for yield higher than what is currently available in bonds, and for those investors willing to accept higher risks, preferred shares can be attractive from both an income and potential capital gain standpoint.

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