Preferred shares are often considered a hybrid security, since they share characteristics of both common stocks and corporate bonds. Like bonds, preferreds typically have a predictable income stream. But unlike bonds, most preferreds do not have a maturity date. And most important, the income from preferred shares is considered dividends rather than interest.
I’ve received many questions about preferred shares over the years: this asset is class is clearly popular with Canadian investors. But the honest truth is that I didn’t have much insight to share: I don’t include preferreds in my model portfolios for DIY investors, and our Toronto team at PWL Capital does not include them in client accounts. But other PWL advisors use them regularly, so I teamed up with my colleague Raymond Kerzérho, director of research at PWL Capital, to write a new white paper on the subject. In The Role of Preferred Shares in Your Portfolio, we describe the different types of preferreds in the Canadian marketplace, consider their risks and potential rewards, and help investors decide whether it’s worth adding them to a diversified portfolio.
In the first of a series of blog posts on this subject, let’s start by considering the reasons investors are attracted to preferred shares.
High yields. The yields on preferred shares often exceed those of bonds—even bonds issued by the same corporation. This isn’t the case during all periods, but in our current low interest rate environment those 4% or 5% dividends look more tempting than ever. The chart below compares the yields of preferred shares and A-rated 10-year corporate bonds for the period 2001 through 2014:
Preferential tax treatment. Bond interest is taxed at an investor’s full marginal rate, but income from Canadian preferred shares is taxed far more favourably, thanks to the dividend tax credit. This makes them a tax-efficient alternative to corporate bonds in non-registered accounts.
The table below outlines these estimated tax savings by comparing the tax liability of $1,000 in interest with the same amount in eligible Canadian dividends. As you’ll see, the benefit is significant for both moderate and high-income earners.
Estimated from 2014 tax rates. Source: KPMG
Low correlation. Investors achieve the greatest diversification benefit when the asset classes in their portfolios move independently of one another. The correlation coefficients in the table below describe the degree to which preferred shares moved in lockstep with other asset classes during the decade from 2005 through 2014. (The lower the figure, the lower the correlation and the greater the diversification benefit.) Preferred shares displayed low to moderate correlation with most asset classes, with most coefficients below 0.50. But I was most surprised to see that they were least correlated with bonds:
|Canadian bonds||FTSE TMX Canada Universe Bond||0.16|
|Real estate||S&P/TSX Capped REITs||0.62|
|Canadian equities||S&P/TSX Composite||0.44|
|US equities||S&P 500 in CAD||0.29|
|International equities||MSCI EAFE in CAD||0.38|
|Emerging market equities||MSCI Emerging Markets in CAD||0.43|
Source: Morningstar Direct
Next week we’ll take a look at whether these characteristics offer enough potential reward to justify including preferred shares in a diversified portfolio.