Picking the right preferred share

Investing in preferred shares can be somewhat tricky because they often come with riders attached. These aren’t apparent at first glance.

You need to ask a financial advisor to investigate on your behalf or do some research on your own.

The most common wrinkle you’ll encounter is that preferreds are often callable. That means the issuing company can buy them back at certain times under pre-set conditions.

Protects stock issuer

This condition is built in to protect the issuer, not the investor. So if interest rates have dropped since the preferred was issued, the company can get off the hook by calling it in. They save money but you lose a good deal.

You may even suffer a capital loss. For example, if you paid, say, $26.50 per share and they’re called in at $25.

So before you buy, be sure to check what the earliest call date is for any preferred that interests you.

Types of preferreds

Here are several types of preferred shares:

1. Floating rate preferreds:

These pay a rate of interest which fluctuates according to market conditions.≈#60; For example, the dividend may be calculated as a percentage of the banks’ prime lending rate or the Bank of Canada rate.

2. Non-cumulative preferreds:

With regular preferreds, if dividends are missed, they have to be made up later before common stock holders can receive any payment.

This is not the case with non-cumulative preferreds, which are often issued by the big banks. So non-cumulative preferreds carry a higher level of risk.

Holders of the non-cumulative preferreds issued by Royal Trust discovered this when the company was sold to Royal Bank back in the 1990s. Although all Royal Trust preferreds were hammered in the stock market, the non-cumulatives fared worst.

However, non-cumulatives also usually offer a better yield than regular preferreds, so you are compensated for the additional risk.

Since it seems unlikely that any of the Big Five banks would miss a dividend payment under current conditions, this looks like a reasonable risk to take.

3. U.S.-pay preferreds:

Some Canadian preferred share issues are denominated in U.S. dollars, and pay dividends in that currency. The banks are especially active in issuing this type of stock.

U.S.-pay preferreds are eligible for the dividend tax credit and offer an opportunity for currency gains at times when the Canadian dollar is falling.

4. Convertible preferreds:

These allow investors to convert to shares of the company’s common stock, according to a specific formula. This feature can produce significant capital gains if the value of the common stock rises well beyond the conversion price.

Fluctuate like bonds

Like bonds, the market price of preferred shares will fluctuate according to interest rates. Most affected will be fixed rate preferred. These pay exactly the same dividend at all times. (With floating rate preferreds, the dividend fluctuates).

If you expect interest rates to fall, an investment in good quality fixed rate preferreds could pay off handsomely, for exactly the same reason bonds do well in that situation.

From the book 6 Steps to $1 Million by Gordon Pape, published by Prentice Hall Canada.