It sounds exclusive. Perhaps even requiring an invitation to purchase. Or maybe it was created for VIP investors only. Fortunately, you don’t need a guest pass, or sign up on a list months in advance to buy. I’ve written about common shares and bonds, preferred shares, in my opinion, fall in between the two of those investment classes in terms of risk and reward. Preferred shares, like common shares and bonds, are traded on the open market like any other equity. Prices of the shares will fluctuate based on investor sentiment and how attractive the yield of the preferred share is to hold.
You may have heard about preferred shares and never really understood enough to invest in them. Perhaps just hearing that it’s some kind of share, it scares you because you are afraid of losing your money. You may ultimately be questioning, what makes a preferred share different from a bond or a common share? And why should I invest in them? Let me start off by discussing some of the benefits of having preferred shares and then I’ll cover the risks that are associated with them.
Preferred shares have a characteristic which gives them a higher priority to pay back in case a company goes through liquidation. Bondholders still remain first in line to collect their principal, but as a preferred shareholder, that puts you second in line. Preferred shares will generally have much better interest payments than bonds because it has increased risk. One characteristic that preferred shares have with common shares is that distributions are considered dividends and not interest payments. The positive side of receiving dividends is that they might qualify for the Canadian dividend tax credit and ultimately a lighter tax bill at the end of the year. Dividends for preferred shareholders must be paid out before dividends for common shareholders. What this means that if a company decides to give a dividend to common shareholders, they will have to pay their preferred shareholders first before any distribution is made.
Some preferred shares may also share a common characteristic like bonds in that a maturity date exists. This means that as you hold the preferred share, not only will you collect a higher interest rate than bonds, but you also get some protection on part of your original capital. This is a double bonus. Not only are you making more money on dividends, but your original capital is also protected from falling to $0.
This is almost sounding way too good to be true. Higher interest rates, some protection on my capital, and a lower tax bill. Why not put all my money into preferred shares? Obviously to every upside there is a negative that is associated with it. Let’s look at some of the cons of owning preferred shares.
Preferred shareholders are not considered debt to a company, but at the same time they are not considered owners of the company like common shareholders. This means that preferred shareholders do not get to share in the success of the company. Imagine if Apple had preferred shares and you bought that instead of common shares. Sure you may receive a nice 5% dividend on an annual basis for your preferred shares, but the real money was made holding common shares. If you held the preferred shares you wouldn’t see your shares soar to the $700 level that Apple had once reached. On top of that, preferred shareholders do not hold voting rights. This means that you get no say on who gets to run the company.
Another risk of preferred shares is the possibility of getting a capital loss on your shares. Preferred shares trade on the stock market just like any other share and the price of preferred shares can fluctuate through the laws of supply and demand. One of the factors that affect preferred shares are interest rate changes. This occurs because preferred shares are always issued with a predefined interest rate that they payout at. If interest rates rise beyond the interest rate being paid by the preferred share, the the value of the preferred share will drop. No one wants to hold a preferred share paying 5% when interest rates at the bank are paying 7%. When this phenomenon happens, you may get stuck holding preferred shares that cost less than when you bought them, which means you might get stuck with a capital loss.
One good thing to note about preferred shares is that the specified dividend payment does not need to be paid. The discretion to pay the dividend is up to the company that issues the shares. If the company has not been performing well, they have the right to not issue the dividend to its preferred shareholders. This might mean that you will be holding a share that pays nothing to you and has very little upside. Just remember though, that if a preferred shareholder’s dividend is suspended, the common shareholders get nothing as well, and may very well experience a loss in their shares’ value as well.
A last risk investors want to be careful about is that some preferred shares have early redemption features. At specified calendar dates in the life of the share, the company has the right to redeem those shares at a specified price. This may have an impact in your decision of whether it is worthwhile to buy the preferred share. Take for instance this situation:
- You buy a preferred share with a face value of $25 for $26 with an effective interest of 5% on the $25 face value.
- You expect to collect $1.25 for holding that share for the year.
- Halfway through the year, the company decides to redeem your preferred shares at $25.50 per share.
- Since you bought at $26 and only collected $25.50, you lost $0.50.
- Instead of collecting $1.25 interest for the year, you collected $0.63 only for half the year.
- Effectively your purchase netted you only a gain of $0.13 instead of $1.25. Effectively lowering your interest to 0.5% ($0.13/$26)
In the above example, the interest rate that you would call on line 6 would be the yield-to-call. If this rate was negative, then there is a remote chance that you could lose money if the company decides to redeem their preferred shares early. In this case, it’s always smart to do some research first before jumping in and buying preferred shares.
There is a lot to learn when it comes to investing in preferred shares. Don’t let that be a deterrence for you in deciding whether to invest or not. Making preferred shares part of your investment portfolio will help provide a steady source of income with the added protection that your capital isn’t exposed to the same risks as common shares. Just like stocks and bonds, the decision of what to purchase may be difficult, but there are many funds that invest in preferred shares. Using these funds, one can invest in preferred shares without all the hassles of maturity dates and calculating yield-to-call ratios, as the fund’s managers and analyst will help you in that regard. All you need to worry about is how much money you’ll be receiving on a monthly basis.
So the next time you see your friends, go brag about how much you know about preferred shares. They will may even think that you have some platinum membership card for that company.