Amid a long bear market for preferred shares come glimpses of why you might want them in your portfolio

Amid a long bear market for preferred shares come glimpses of why you might want them in your portfolio

By Rob Carrick
The Globe and Mail, April 17, 2020

The slow accumulation of companies cutting their dividends is taking some of the stink off an investment category that has been frustrating investors for years.

Preferred shares have been in a bear market of roughly 10 years in length and were utterly savaged in the March stock market crash. They’ve rebounded a fair bit since then, but that’s only part of the reason why investors should reassess them right now.

In uncertain times, preferred share dividends offer more security than dividends paid on the common shares that fill most investor portfolios either directly or through exchange-traded fund and mutual funds.

“Common share dividends can be cut quite easily,” said James Hymas, president of Hymas Investment Management Inc. and an authority on preferred shares. “Preferred share dividends can only be cut when the common share dividend goes to zero.”

The economic impact of the pandemic has already started to squeeze companies to a point where they are cutting their common share dividends. A quick sampling: ARC Resources Ltd., CAE Inc., Cenovus Energy Inc., Inter Pipeline Ltd., Richelieu Hardware Ltd. and Shawcor Ltd.

Dividend cuts are not the problem with preferred shares. The real issue is that roughly two-thirds of the preferred share market is made up of rate reset shares, which were developed more than a decade ago to navigate a world of rising interest rates.

Except for brief flashes, rising rates never materialized. And then came the pandemic, a health emergency that rocked the economy to a point where central banks in Canada and elsewhere have had to push rates to near zero.

Rate reset preferred shares were issued with a yield based on a premium over the five-year Government of Canada bond yield, averaging 2.5 to three percentage points. Every five years, the shares reset to reflect the yield environment of the moment. With five-year Canada bonds yielding around 0.5 per cent at mid-week, investors are looking ahead to future resets and seeing disappointingly low yields of just 3 to 3.5 per cent or so based on the standard $25 issue price.

Investor advocate Ken Kivenko has heard from between 20 and 25 investors in the past three weeks or so who are upset about both price declines in preferred shares and the potential for a dividend being reset at a lower rate. Many understood their preferred shares to be “fixed income,” a term that usually refers to bonds.

“One woman told me, ‘I said to my adviser that I don’t want risk and I don’t want trouble, I just want a certain amount of income,’” Mr. Kivenko said.

Therein lies the contradiction of preferred shares right now. They do offer reliable income in terms of the set premium over five-year Canada bonds, but they’re awfully volatile in price. Globeinvestor.com shows the S&P/TSX Preferred Share Index with a decline of 19 per cent for the three months to April 14 and a decline of 17.8 per cent for the S&P/TSX Composite.

The preferred share index was down more than 30 per cent from its pre-pandemic peak to its March 23 trough, but then bargain hunters stepped in. “There was a growing sense that the yields available were completely ridiculous,” Mr. Hymas said. “At the bottom, you had the bluest of the blue chip companies yielding 7 per cent on their dividends.”

A quick refresher on falling share prices and dividends: When stocks fall in price, their dividend yield rises. Mr. Hymas said that six months ago, rate reset preferred yields were in the 5.5 to 5.75 per cent range.

Even after the recent rebound, there were still some attractive preferred share yields available as of earlier this week. John Nagel, managing director of preferred shares at Leede Jones Gable, offered a list of big bank rate resets with yields ranging from 6.5 to 8.1 per cent that you’ll find in the accompanying chart (along with five more picks).

Nuggets from the Preferred Share Bargain Bin

Five preferred shares highlighted by John Nagel, managing director of preferred shares at Leede Jones Gable…

IssuerTickerPriceCurrent Yield
Royal Bank of CanadaRY-PR-R-T$24.505.6%
Pembina Pipeline Corp.PPL-PR-K-T$21.346.7%
BCE Inc.BCE-PR-Z-T$11.858.2%
Power Corp.POW-PR-A-T$22.206.3%
Brookfield Asset Mgt.BAM-PR-B-T$7.645.6%

… and a sampling of bank-issued rate resets (all resetting in 2023-24)

IssuerTickerPriceCurrent YieldSpread Over
5-Yr GoC Bond
Bank of MontrealBMO-PR-E-T$16.767.2%2.68%
Bank of Nova ScotiaBNS-PR-I-T$16.357.4%2.43%
CIBCCM-PR-S-T$14.437.7%2.45%
Canadian Western BankCWB-PR-D-T$23.446.6%4.04%
National Bank of CanadaNA-PR-G-T$15.208.1%2.77%
Royal Bank of CanadaRY-PR-S-T$16.907.1%2.38%
Toronto-Dominion BankTD-PR-M-T$19.656.5%3.56%

Source: John Nagel, globeinvestor.com. Note: Market data as of April 14

Preferred share performance

Additionally, the highlighted five examples from the universe of rate reset issues with a minimum dividend (a kind of floor rate) that were issued by Canadian Utilities (CU.PR.I), Brookfield Asset Management (BAM.PF.H), Emera Inc. (EMA.PR.H), Enbridge (ENB.PF.K) and Westcoast Energy Inc. (W.PR.M). “These are shares that I think will hold their value the best,” Mr. Nagel said.

Preferred share dividends are more secure than common share dividends, but defaults have happened in rare cases. Mr. Hymas said these defaults are rare because the total amount of preferred share dividends paid out by companies tends to be a comparatively small corporate expense. Also, a company is considered to be financially failing when it suspends preferred share dividends. “It is extremely difficult for a company to get financing once it has pulled that trigger.”

There are two main types of preferred shares – rate resets and perpetuals, which pay a fixed dividend. Perpetuals typically behave more like bonds, rising in price when rates fall and losing ground when rates rise. However, Mr. Hymas said perpetuals have been lumped in with rate resets lately and have not done well, either.

Looking ahead, perpetuals could theoretically benefit to some extent from low or falling rates. Expect more grief for rate resets and the exchange-traded funds and mutual funds that hold them if rates fall.

The long bear market for preferreds has largely been a result of expectations for higher interest rates being met with a low-rate reality. Waves of investors have come into rate resets thinking the sector was bottoming out, only to be surprised by further price declines.

Why consider rate reset preferreds at all, then? Mr. Hymas says their yields are attractive now and would remain so even if they undergo a dividend reset at today’s depressed rates. And, as we wait for the pandemic’s impact on the economy to hurt corporate profits, there’s the added level of security over common share dividends.

The do-not-ignore caveat: Forget about preferred shares altogether if you want a secure investment that doesn’t change much in price. “Preferred shares are volatile beasts and you shouldn’t buy them for preservation of capital,” Mr. Hymas said. “They are all about preservation of income.”