Does Your Portfolio Need Preferred Shares?

Last week’s blog introduced a new white paper, The Role of Preferred Shares in Your Portfolio, coauthored with my colleague Raymond Kerzérho, director of research at PWL Capital. That article looked at the reasons investors might consider adding Canadian preferred shares to a diversified portfolio: namely high yields relative to corporate bonds, tax-favoured dividend income, and low correlation with other asset classes.

Those are three tempting reasons to use preferred shares. But as Raymond and I explain in our paper, the overall risk-reward trade-off in this asset class is not particularly compelling. In my opinion, most balanced portfolios would likely be better off without preferred shares. For those who want to add them to the mix, we make the following recommendations:

Only use preferreds in non-registered accounts. While preferred shares may be a diversifier in any portfolio, their largest benefit is their tax-advantaged dividend income. If you need current income from a non-registered account, preferreds can be a good alternative to corporate bonds, which are often very tax-inefficient. While preferreds carry more risk than bonds issued by the same corporation, this tax advantage should provide adequate compensation.

We do not believe preferred shares are appropriate for tax-sheltered accounts such as RRSPs or TFSAs. Once you remove their tax advantage, preferred shares do not offer sufficient returns to justify their additional risks compared with high-quality bonds.

Keep your allocation small. There is no perfect rule to determine the maximum weight that should be allocated to preferred shares. But given the risks and limited rewards, we believe most investors should limit their exposure to about 5% or 10% of their overall portfolio. This might be pushed to 15% for investors who have a large allocation to fixed income (70% or more) in taxable accounts.

Diversify broadly. Diversification is always important, but it is paramount in an asset class that has little upside potential. If you hold a small number of preferred shares, there is little or no opportunity to recover from the default of one issue, since preferred shares deliver their value gradually over time, piling up small gains in the form of dividends. Credit losses are rare with preferred shares, but they are potentially devastating, so it is crucial to diversify across many issues.

Don’t invest in individual preferreds. Many investors attempt to diversify their preferred share holdings by selecting a number of individual issues. But we believe investors should avoid individual preferred shares for at least three reasons:

  • It is difficult to get adequate diversification with individual preferreds. Holding 10 or 20 issues does not provide enough protection, and assembling a portfolio with a larger number of holdings is impractical for most investors.
  • The complexity of preferred shares makes it extremely difficult to select individual securities. While it is tempting to look only at yield and credit quality, investors also need to have a complete understanding of the embedded options and other features in each issue, and few people have the skill to do so. This complexity makes selecting preferred shares challenging for retail investors, and even advisors.
  • Individual preferred shares are notoriously illiquid. They frequently trade with wide bid-ask spreads, making them expensive and difficult for investors to buy and sell.

When advisors at PWL Capital use preferred shares in client portfolios, they typically use the BMO S&P/TSX Laddered Preferred Share (ZPR). This ETF has the benefit of relatively low cost (0.51% MER), broad diversification (over 140 issues), and much better liquidity than you would get from holding individual preferreds. It also includes only rate reset preferred shares, which carry less interest rate risk than perpetual preferreds (this idea is explained in the white paper).

In my next blog, I’ll explore a controversial idea: are preferred shares an asset class where active management can add value over an indexed approach?

 

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