Preferred Shares

July 26th, 2010 by Potato

Terence asked via email if I could comment on Garth Turner’s investment philosophy.

Garth of course is perhaps the most well-known real estate bear in Canada — it was his writing that lead me to look into the issue myself before potentially buying a house in 2006 (we ended up renting instead).

He also provides a bit of investing advice on his blog (and his book Money Road — which I have not yet read). He very often gets asked by readers (or “blog dogs”) what they should do with all the money they have if they do sell their house, or hold off on buying their first if they do have a downpayment. One of the things he recommends very often on his blog are preferred shares of the Canadian banks (and also insurers, utilities, etc) which pay in the neighbourhood of 5-6% these days, as a tax-advantaged dividend.

First up, what is a preferred share? It’s a bit of a strange beast that lies somewhere between a stock and a bond. You get a regular payout, like a bond, but it’s counted a dividend for tax purposes, like a stock. But, you don’t share in any upside of the company’s growth or progress, like a bond. Preferred shares fall between common equity (regular stocks) and bonds (and other debtholders) for getting paid back in a liquidation — something that is unlikely to be an important factor, as when companies do get liquidated these days, even the bondholders are seldom made whole, so the preferreds usually end up worthless as well (at least from what I’ve seen). The preferred dividend can, in hard times, be cancelled, but must generally be paid before the common dividend can be reinstated. As long as the company in question is doing moderately well, the preferred (and bonds) should continue to pay out, even if the common goes nowhere. Each preferred issue has its own set of rules, and even within one company there can be many series (often denoted with a letter) that play by different rules. Often they have a “par value”, a price at which the company will buy them back. Redemption though can be at the company’s option, not the holder’s.

All said, they typically offer a steady stream of income that is in-between a stock and a bond for riskiness, but far more tax-advantaged than a bond.

Now, there are several things to keep in mind when you see Garth recommending these things. The first is the audience: many people don’t think there is a way of getting more than 1% in a bank account or GIC without taking on the full risk of the equity market. He’s pointing out that there is something that will pay a consistent return — more return than many people are getting from the rent savings by owning their houses these days — and that will pay it similar to how a GIC/HISA pays out, i.e. fixed and regular, without the uncertainty of return that’s inherent to capital appreciation. Also, the audience tends to be either baby boomers who need income for retirement (or to pay the rent if they sold off their nearly-paid-for houses), or newbies who don’t know that there are ways to get their money working in a relatively low-risk way.

Related to that is the idea of tax efficiency: for someone with nearly no income (a grad student like me) or lots of tax shelter room, finding a bond at 5.5% is equivalent to a preferred at 5.5%, so why not go with the bond since it’s a little safer? But for someone in a higher tax bracket, who just sold a paid-off house, that preferred at 5.5% may beat out a bond at 8% due to the tax advantage.

Also, it’s a rhetorical device: as I said above, it’s a good example of a way to make a decent return to someone that doesn’t know anything beyond “the dutch guy’s shorts.” He’s not recommending that people buy only preferreds, but since it’s one of the less-discussed options (stocks and bonds get hundreds of times more thoughtspace and attention than preffereds do) it makes it worth talking about, both because it gives him a somewhat unique message, and because it helps educate his audience. When he does give investment advice on the Greater Fool blog, he’ll spend most of it talking about preferreds (or rather quipping one-liners about preferreds), but he’s not by any means recommending that people only buy preferreds.

Finally, Garth’s outlook is that the overall market will be choppy but generally flat, if I’ve read his message right, so he doesn’t see much of a risk premium for stepping up from preferreds to commons. If that’s your viewpoint, then locking in a mid-5% return is quite good. Vice-versa, the spread between a company’s debt and preferreds are quite high right now, also indicating they may be worthwhile, though I’m having trouble finding out what the historical spread was.

Terrence also asked about the interest rate sensitivity, pointing out that preferreds may have been a good investment recently because interest rates have gone down (similar to bonds, preferred prices go up as rates go down). Now, these will have some interest-rate sensitivity, and due to the perpetual nature of many (the company calls them back for redemption rather than the holder), you get a little less protection than a bond (which can be held to maturity). However, if you don’t have to trade them, then the changes in the price is not too much of a concern, and being able to lock in today for a ~5.5% dividend is not too shabby, considering 5-10 year bonds from the same banks are only in the 3-4% range right now. If you do need to sell within a few years, then you can get hurt by the fluctuations in price. One note though: due to not knowing when a preferred will get called, there’s the concept of “yield to worst”. If you buy a preferred with a high coupon, that is, after interest rates had dropped, so the price went up, the redemption price the company can call it at is still say $25. So if you paid $26 and are getting some quarterly payment as well, your yield to worst would be lower than the cash yield since the company could call the preferred back at $25, giving you a $1 loss at the end. Another risk to watch out for when talking about changing interest rates and buying/selling preferreds.

So all that said, what do I think? Well, I think for the target audience, they’re a great investment vehicle. But for my audience, which is typically younger, they’re not really worth looking into. If you’re a little older and starting to become more conservative in your risk tolerance, and also wealthier, then they can be great: as you shift more towards fixed income, you may very well want to subdivide your focus to spread out amongst a 5-year bond ladder, some longer bonds, some corporates, some real return, and of course, some preferreds. For a younger, poorer audience, with higher risk tolerance, I figure fixed income should be a fairly small portion of the portfolio, and what fixed income there is should be ultra-safe (HISA/GICs/Government bonds) since it’s function is to be the security blanket, or the money needed in the near-to-middle term that can’t be put at risk — and there likely won’t be enough fixed income to make it worthwhile sub-dividing the category so finely.

The added complication of each series having its own rules on redemption, dividend payout adjustments, etc., also means there can be a lot of reading involved for a fairly illiquid instrument. There are some preferred ETFs that can help make buying some easier, but still, I don’t see the point for someone who’s got decades of time to get the rewards promised in common equity.

That said, just ’cause you’re young doesn’t mean you have the same risk tolerance I do (and there may be older folks amongst our readers too!) so if anyone out there is interested in learning more about preferreds, feel free to ask any questions and I’ll try to help out!

4 Responses to “Preferred Shares”

  1. wayfare Says:

    “…to someone that doesn’t know anything beyond “the dutch guy’s shorts.””

    What if you’re someone that doesn’t know know anything up and to including what “the dutch guy’s shorts” means?

  2. Potato Says:

    It’s Garth Turner’s slang for ING Direct (and other HISA). Cash, basically.

  3. Ter Says:

    Thanks for the post… definitely good to hear another opinion on the topic!

    You’ve touched on a lot of the points that I’m concered about. Problem is that most of the fixed-reset preferreds (the ones that will likely be called at $25 in a few years) are currently trading at $27+, with yield-to-worst of ~3.5%, including the capital loss – which is not good for those of us with held-over losses from 2008/9! Not quite as attractive, but still better than a HISA.

    BTW, I never did understand the “dutch guy’s shorts” nickname… have we seen his shorts in the commercials? I think I’d remember that visual… ;)

  4. Potato Says:

    Well, if they’ve got a good chance of being called in a few years, then you don’t have the duration risk of some of the other perpetuals. At least the income is as a dividend, and the 5-year government bond rate is ~2.5% right now, so it’s a decent premium…