Why Canadian preferred shares deserve a space in your portfolio

• Canadian preferred shares remain fairly valued, despite the higher risk of recession and lower interest rates that come with it.
• With a current yield of 4.75% or so, you will still enjoy a decent spread over Canadian Government bonds, notwithstanding the risk of interest rate fluctuations.
• Given the limited potential for value added from active portfolio management, investors would be better off with a cheap, passive preferred shares index or exchange traded fund.

When we laid out our suggested portfolio positioning moves for 2019, we advocated a healthy exposure to Canadian preferred equities. At the time, the big question was whether it was a good idea to load up on such shares in a scenario of heightened recession risk. The idea was (and it still is), that the category continues to trade at significant discounts to par values, with a healthy premium over Government bonds.

What has since changed is GDP growth forecasts and interest rate expectations. At the beginning of the year, there were high hopes that the Canadian economy was just going through a soft patch and that a rebound in the second half of the year was highly probable. At the time, Mr. Poloz' thinking was that interest rates were sufficiently low to stimulate the economy, and that there was room for further hikes later in the year. With the most recent data, showing that the economy grew at an anemic 0.1% in the last quarter, expectations have shifted. The probability of lower short-term rates has now risen considerably. Until we see concrete signs of economic strength, there will be no mention of higher rates any time soon.

To assess how your preferred shares portfolio would respond to lower rates, if that happens, it is important to understand how the corresponding dividend rates are structured. The web is full of material on what a preferred share is. So we will not waste much time explaining what you already know. We will only highlight a couple of key characteristics that are bound to impact your future expectations.

As a preferred shareholder you practically rank ahead of common shareholders, but behind creditors, on all counts. If a company goes bankrupt, the proceeds of its assets' liquidation will be first distributed to lenders. The remainder, if any (usually there isn’t much left!) goes in ranking order to preferred shareholders, and then to common shareholders. This is why, from a risk perspective, preferred shares are considered riskier than bonds, but superior to common shares.

In terms of dividend distributions, preferred shareholders rank ahead of common shareholders. This is important. A company cannot pay any dividends to its common shareholders unless it pays the preferred shareholders first. In other words, a company cannot eliminate or even reduce preferred dividends before eliminating altogether all common stock dividends. This characteristics has profound implications on the safety of your dividends.

For example, it is not uncommon for companies, particularly in cyclical businesses, like automotive, or commodity-based businesses (including energy) to reduce their common stock dividends. They often run out of free cash flow, or their lenders force them to cut dividends. However, when they do that, they still have to continue paying preferred shareholders. Under very dire circumstances, they may be forced to do suspend all forms of dividends, including the preferred. The GM’s, Fords, Bombardiers and many energy and base metals companies of this world have done it before.

However, companies in the financial (banks and insurance), utilities, pipelines, telecommunications or REIT sectors would rarely suspend all dividends. The main reason people buy their shares is to get the dividends. Even if they suspend common stock dividends (let alone preferred), no one will buy their shares. They know it. Thus the risk of that happening is very rare. The only time it happened in recent history was when some US banks stopped their dividends during the sub-prime crisis, under very extraordinary circumstances. In Canada, the risk is much lower. Some Canadian banks have been paying dividends, without interruption, since the late 19th century!

This is why preferred dividends, particularly if you focus on the aforementioned sectors, are much safer than common dividends. And if you invest in a mutual fund, or an exchange traded fund, you’re actually looking at a very diversified portfolio, which makes it even much, much safer.

The other issue to consider is the risk of interest rate fluctuations and how it impacts preferred shares prices and dividend distributions. To assess such risk, we need to go through the different dividend payment structures of preferred shares. There are typically three main dividend structures:

Floating dividends: in such cases, dividend payments are tied to a short-term benchmark such as the Canadian prime rate, or short-term treasuries. Some dividend issues are tied to the Canadian Government 5-year bond rates. As a result, corresponding preferred share prices go up and down with Canadian short-term interest rates.

Fixed with 5-year reset: this is a very common structure in Canada. Here, dividend payments are fixed for a period of five years and are typcically locked at a pre-defined spread (say 2-3%) over the Canadian Government 5-year bond. Each five years, the dividend rate is adjusted based on the 5-year bond yield prevailing at the time, while maintaining the same spread. Thus, the impact of interest rate movements will vary depending on the reset date of each individual issue. If the reset date is 5 years down the road, the price will behave like that of a 5-year bond. If the reset date is close, the issue starts to behave like a floating rate instrument.

Fixed: in this case, the dividend rate is fixed with no reset. These are highly risky issues and are extremely sensitive to interest rate movements. They typically behave like ultra long-term bonds.

The result is a mixed bag of issues, each reacting in a different way to interest rate fluctuations. That said, the vast majority of Canadian preferred shares have floating or fixed dividend rates with 5-year reset. On balance, prices in the short-term tend to drop in tandem with interest rates and vice-versa. For example, in the period between 2015 and 2016, when 5-year bond yields dropped by a full one percentage point or so, the average preferred shares portfolio lost more than 30% of its value. Some of these losses have since been recovered, but if you bought preferred shares back in 2014, you would now still be in the red.

If the risk of lower interest rates (and lower share prices) has now increased that much, why are we still advocating preferred shares? Well, there are at least three reasons:

First, preferred shares have, on average, lost between 10% and 15% of their values since last October. Currently, most issues are trading at discounts ranging between 20% and 35% of their par value. Therefore, some of the downside has already been priced in.

Second, when you invest in preferred shares, you do it for long-term dividend streams, not for speculation on short-term share price movements. And you never invest any funds that you might need in the next few years. If you follow this rule, with a current dividend stream of roughly 4.75% per nannum, you would be earning a decent spread of 3% or more over 5-year Government bonds. This is a very good risk premium for an asset class that is less risky than common equities. In the long term, you are fairly shielded from the risk of inflation and that of higher interest rates.

Third, if you are investing outside your RRSP, you benefit from the dividend tax credit, which significantly enhances your net income versus fixed income instruments.

In our update of January 1st, we highlighted that preferred shares are ideal for pairing with high yield common equities. The two classes typically move in opposite directions, as one benefits from lower interest rates while the other suffers from it (and vice versa). So you have a near-perfectly diversified combination that hedges your bets against both scenarios, while rewarding you with a generous income stream.

In terms of specific funds, you would clearly be better off with a cheap, passive index, or exchange traded fund (ETF). All the major fund and ETF companies have several options. Just go for one with low fees, because the cheaper the fund, the more dividends in your pocket. There is nothing compelling in the actively managed space, simply because there is very limited potential to add value from active portfolio management.

March 13, 2019

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