Preferred shares or bonds?

Question: I have read most of your books, as well as those of several other personal finance and investment writers, however I don’t recall coming across a comprehensive yet understandable discussion of the relative merits of preferred stock shares versus corporate bonds, particularly for a RRIF. Specifically, what criteria should be used in deciding between, for example, a Royal Bank bond yielding 6.5% and Royal Bank preferred shares also yielding 6.5%? Does the bond’s coupon rate matter, or is the current yield all that’s important? The fact that either issue will likely be purchased in the “secondary market” also muddies things in my mind. Is it preferable to buy “new issues”? Is this even possible?Answer:

If you’re investing outside a registered plan, the preferred shares have the edge because the dividend they pay is eligible for the dividend tax credit. That means your income will be taxed at a lower rate than if it comes from a bond, which pays interest.

Inside a RRIF, it’s a different story, however. The dividend tax credit has no bearing since all money taken out of a RRIF is taxed at your marginal rate, whatever the originasource. So you need to apply some different criteria. These include:

1) Term to maturity or next call date. All bonds and most preferreds have a maturity date. Many preferreds can also be called at the option of the issuer, which is usually done if the coupon rate is higher than the market rate at the call date. Before you invest in any security of this type, find out how long you can hold it for. The call date may be just months away.

2) Yield to maturity. The coupon rate means little if you are buying a bond or a preferred in the secondary market (yes, you can buy new issues, check with your broker). Even the current yield may not mean a lot if the bond or preferred is priced at a significant premium or discount to par. For example, a preferred with a current yield of 8% may look very attractive – until you probe further and see that it is trading at $26.50 but can be called at $25 in 12 months. That means you would suffer a capital loss of $1.50, which would significantly reduce the yield to maturity which takes into account both the interest/dividends and any capital gain/loss.

3) Credit standing. Bonds take precedence over preferreds in the pecking order if the issuing company runs into financial difficulty.

4) Payment method. There are two main types of preferred shares – fixed rate and floating rate. The fixed rate preferreds pay the same dividend at all times. The floating rate preferreds pay a variable dividend that is based on a standard measure such as the Bank of Canada rate. Most bonds pay a fixed interest rate, except real return bonds – their rate is adjusted to reflect changes in the cost of living index.

5) Capital gain/loss potential. Fixed-rate securities have greater potential for capital gains or losses than those with a floating rate.

Generally, when all the variables are sorted out, bonds from comparable issuers will be found to produce better returns for purposes of a RRIF.