Preferred shares: Higher income with higher risks

Like long-term bonds, preferred shares tend to be sensitive to interest rates, with their prices declining when interest rates rise, and vice versa. Preferreds with fixed dividend rates – which now represent a relatively small portion of the market – are generally the most sensitive to interest rates. As bonds approach maturity, their prices move toward par value, but preferred stocks do not because they have no maturity date.

Consider the following example: If interest rates rise by 1%, the price of a 20-year bond with a 5% coupon would decline about 11.6%. The price of a 5% fixed-rate perpetual preferred share would decline approximately 16.7% according to Edward Jones calculations. The lack of a specified maturity for the repayment of principal makes preferred shares more sensitive to changes in interest rates.

Rate-reset preferreds may be less sensitive to interest rates because their dividends would increase if the index rate rises, which would partially offset higher interest rates. Nevertheless, market prices of rate-reset preferreds can still fluctuate substantially, especially if long-term rates rise more than intermediate-term rates, referred to as a steepening yield curve. However, if long-term rates fall more than intermediate-term rates, the potential for price appreciation is generally be limited to the call price.

Most preferreds can be redeemed by the company, typically five years after issuance at a specific price known as the call price. This effectively caps the value near the call price, which is typically at or slightly above par value. It is generally beneficial for companies to redeem preferreds when rates decline, so investors may have to reinvest at lower rates, known as reinvestment risk.

Preferred dividends can be suspended or cancelled by the issuing company. Although this can typically happen only if common stock dividends are also suspended. If the preferred dividend is cancelled, the preferred share could drop in value significantly since it would pay no income and have no maturity. Even if the perceived risk that the dividend could be suspended – known as "credit risk" – increases, the additional yield to compensate for this risk – referred to as "credit spread" – will typically also rise. This would, in turn, increase the yield required for investors to buy or hold the preferred, likely pushing the price down. Preferreds tend to be more sensitive than bonds to an increase in a company's credit risk since preferred dividends can be suspended or cancelled at management's discretion, while failure to pay interest and principal on bonds typically results in bankruptcy. As a result, preferred share dividends could be interrupted while bond interest payment would continue to be paid.

Subordination refers to the order of priorities in claims on a company. Preferred shares rank lower than bonds and most other claims on a company, such as pensions, leases and bank deposits. As a result, preferred-share holders could receive a very low recovery in bankruptcy.

Most preferred shares issued by banks, known as non-viability contingent capital ("NVCC") or contingent convertibles ("CoCos"), can be converted to common stock. This can be done in certain circumstances, such as the bank being deemed by the regulator as no longer viable or the bank receiving capital from the government to avoid becoming non-viable. In this scenario, the value of the common shares received could be much lower than the par value of the preferred shares converted.

Dividends on preferred shares (and common shares) of large Canadian corporations that pay income taxes are generally considered "eligible" for tax purposes. This means holders may be able to receive federal and provincial dividend tax credits, which reduce the total tax owed. If held in taxable accounts, this may be a benefit over interest income on bonds, which are generally taxed at the investor's income tax rate. Please see a tax professional for specific tax considerations for preferred shares.

Preferred shares have delivered lower investment returns than high-yield bonds over time, as shown in the chart below. While the performance of any particular issue will vary, preferred shares have generally underperformed high-yield bonds. Volatility of preferred-share returns – a common measure of investment risk based on how much returns fluctuate – has also been higher than that of high-yield bonds, indicating higher risk. Additionally, preferred shares tend to move in the same direction as Canadian common stocks – known as "correlation" – more than high-yield bonds do. This suggests that preferred shares provide less diversification to common stocks than high-yield bonds do. For these reasons, we recommend that investors who seek higher income and can tolerate higher risk should consider high-yield bond mutual funds or exchange-traded funds rather than preferred shares.