Preferred Stock Basics (Montreal Gazette)

A mini-primer on preferred shares


By JOHN ARCHER, Freelance December 7, 2009

With interest rates remaining stubbornly low, investors hankering for yield are finding slim pickings in the term-deposit and bond market.

One area of fixed income investing that tempts yield seekers is the preferred-share market, where yields are ranging from four per cent to 6.5 per cent. Preferred shares remain a mystery to the average investor, however, so here is a quick primer.

Preferred shares carry attributes similar to bond and stock investments. Preferred shares, like common shares, represent a form of ownership in a corporation.

The fact that preferred shares are traded on a stock exchange sometimes confuses investors, whereas preferred shares should be purchased primarily as and evaluated against fixed income instruments.

Some characteristics are common to all preferred shares: As an equity investment, preferred shares rank above the interests of common equity holders. As well, the preferred-share investor is entitled to a set rate of dividend that must be paid out of earnings before any dividends are distributed to common shareholders. It should also be noted that dividends receive favourable tax treatment relative to other forms of income.

Finding value in the preferred-share market can be a challenge for the individual investor, which is why using an adviser is recommended. Furthermore, preferred shares can be bought only through an investment dealer, though dividend mutual funds are more widely available.

The following factors should be considered before making a preferred share investment: Calculate the yield on the investment. The easiest way to evaluate the yield on a preferred share is to measure the current yield - the dividend divided by the market price. Current yield, however, does not account for accrued dividends, capital gains or losses realized when the share is purchased at a price different from the redemption value, or the lower taxation rate on the dividend income.

A different measure of yield for preferred shares is the "bond-equivalent yield," which provides an all-in rate of return (based on purchase price, dividend payments, lower tax rates on dividend income, and the maturity value). The bond-equivalent yield is then compared with bonds of similar term to provide a gauge of relative value. The greater the difference (spread) between the preferred share's bond-equivalent yield and the yield on Government of Canada bonds of similar term, the greater the value to the investor.

Other factors to consider in purchasing preferred shares include knowing the issuer's credit rating. Investors should also understand other risks associated with preferred shares, like interest rate risk, as preferred shares are often affected by changes in interest rates. Should interest rates rise, existing preferred share prices may fall. The longer the preferred share's maturity, the more sensitive it will normally be to interest rate changes.

While there might be a learning curve involved in adding preferred shares to your income portfolio, comparing their superior yields to those of other fixed income investments should reward you in today's low interest rate environment.

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