No shortage of risk in preferred shares

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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.

Another risk may be less obvious: preferreds are primarily a retail market. Institutions such as endowments and pension funds have little interest in the market, because they can’t benefit from the tax advantage. Thus, preferreds are more illiquid than other investments, and thus enjoy less of a liquidity premium.

Hymas estimates that preferreds trade at a yield of 195 basis points over equivalent corporate debt. Of that, 10 basis points can be attributed to credit risk. The rest is a liquidity premium.

“Liquidity is extremely important in the preferred share market; you can make excess returns by selling liquidity and you can get make horrible returns by buying it.”

Justin Bender, an advisor at PWL Capital in Toronto echoes that. Preferred shares were not immune to the debt crisis of 2008-2009, when investors fled to the security of government bonds. “When you want to get out of those things, they’re not liquid and you’re not going to be able to sell them. We had a few clients who had to sell preferred shares and it was a nightmare.”

Still, preferreds can be an attractive part of a long-term portfolio.

“It depends a lot on the time scale that you want to look at,” says Hymas. “On a day-to-day basis, individual issues can vary considerably and also on a day-to-day basis the market as a whole can do very extreme things for various reasons. However over the long run, the market is only a little bit more volatile than long corporate bonds.”

If preferred shares are to be considered part of a fixed income portfolio, they should be compared to long-term bonds—those with a maturity over 10 years—rather than the Government of Canada five-year bond or the prime rate.

That’s not, generally, how people think when they look at preferred shares, which can come in a variety of forms. There are the perpetuals that the banks frequently issue—shares that the bank may call back if they find a cheaper source of capital. Then there are shares that can adjust the dividend they pay at specified intervals. These shares have floating rates or rates that are reset.

“There are two major components to the prices: the credit risk and the interest rate risk,” Hymas explains. “The fixed resets and the floaters address the interest-rate part of the equation but they do not address the credit risk part of the equation. So a lot of people tend to buy fixed resets, for instance, on the grounds that they are just five year issues, but that is not correct. The interest rate risk might be about five years, but the credit risk is forever.”

On credit risk, PFD1 indicates stability as good as a bank; PFD 2 ratings are equivalent to an investment grade corporate bond, while PFD 3 is more like a good high-yield bond.

That said, Hymas advises against buying solely on yield.

“A lot of people attempt to build fixed income portfolios from the bottom-up, which is a horrible mistake. A fixed income portfolio should always be built from the top down, meaning that you first understand what the client is attempting to accomplish with his portfolio and then pick pieces out of the jigsaw puzzle that fit. It’s simply a question of keeping in mind what the client is attempting to do.

“Simply ‘making money’ is not an investment plan, though there are many advisors who will tell you different.”

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