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Bonds aren’t yielding what they used to—a five-year government of Canada bond will get you 1.5%. Equities, however, are levered to economic performance, and thus would seem to be a better vehicle for growth. Companies are sitting on hoards of cash that could be paid out as dividends, but a conservative investor may not want to take on stock market volatility.
Preferred shares would seem to be a viable alternative. They offer higher yields not only than government bonds, but also investment-grade corporate bonds. They are rated by credit agencies. And they tap directly into a company’s cash flow. Finally, because they pay dividends, rather than interest, there’s a tax advantage.
“I think from a yield perspective, preferreds are pretty attractive,” says Dan Hallett, director of asset management at Highview Financial Group in Oakville. “What you give up: you’re always taking a bit more credit risk; you’ve got potentially more duration risk as well—it depends on the issue.”
Preferred shares are often considered fixed income vehicles, but they are not as simple as government bonds. One reason is because they are a way for financial institutions to raise capital without diluting their equity base. A second reason is because they rank lower in a company’s capital structure than senior bonds, but higher than common equity. That gives rise to complications investors need to pay attention to.
“I think there’s greater complexity to the preferreds because of the different call provisions; they are just not as well understood,” says Hallett. “I think in general you tend to have a bit more credit risk, in that you stand behind bondholders.
“The stuff trades on yield. That’s a dangerous thing for the less knowledgeable investor, but certainly a better opportunity for those who know a bit more about it and know how to handle it.”
The market for preferreds is thriving; as banks shored up their Tier 1 capital ratios in recent years, the market was flooded with new preferreds.
“One thing to consider is who benefits from new issuance. There was a big spike in spring 2009 when all of the banks were busily raising capital hand over fist,” notes James Hymas, who blogs on preferred shares and runs the Malachite Aggressive Preferred Share Fund. “We’re certainly not back to those levels yet, but on the whole the preferred share market has grown considerably over the last 10 years. There are a lot of new issuers coming out and some of the old issuers are starting to put their toes back into the water.”
Because of their place in the credit structure behind bondholders, investors could be wiped out. Hymas notes two major issues that have defaulted: Nortel and Quebecor World.