Understand Preferred Shares | Key Investment Considerations
The US Fed Funds Rate and Bank of Canada Benchmark Interest Rates are at all time lows at 0.25%. This has resulted in getting yield on investments harder than ever, especially in the bond market. One alternative to investing in corporate bonds is to own preferred shares, and can be a good place to find yield at this time.
What is a preferred share? It is an asset class somewhere in between common stocks and bonds. Some of the key differences from the common stocks is that preferred stocks don't carry any voting rights. But, the benefit is that they have priority over a company's income meaning they are paid dividends before common shareholders. Furthermore, if a company goes bankrupt common shareholders are last in line to get paid meanwhile preferred shareholders are second last behind creditors and bondholders.
The reason why people often compare preferred stocks to bonds is that they have a par value, and they have a dividend based upon this. Like bonds a major driver for the value of preferred stock is interest rates. When rates go up the value of preferred shares tends to decline, and visa versa. The key to this is that they "tend to" and this isn't always the case. Even though rates are depressed many preferred shares are trading well below par value unlike bonds issued in some cases by the same companies.
Part of this could be future expectations at play, and the fact preferred stock while safer than common stocks, aren't as safe as bonds. Hence the market is factoring a higher risk premium with preferred shares than they are with bonds. Part of the reason for the size of the divergence may have to do with government interference, where governments have been active in the corporate bond market making purchases through ETFs in both Canada and the United States to support economy during the pandemic.
Some other things to take into account is that preferred shares unlike common shares are redeemable at a par value which in Canada is usually $25.00. Therefore, when purchasing preferred shares that trade at a discount to par value there can be an opportunity for the shares to be called back at a premium. Usually the market would anticipate this and the price of the preferred would run up. Conversely, the opposite would be true if the price of the preferred was trading above the par value.
Furthermore, The dividends of preferred shareholders are typically fixed like bonds while those of common shareholders can be more variable. That said the distributions of preferred shareholders can usually still be adjusted based on a bench mark rate, and as the distributions are dividends as opposed to interest there is a tax advantage that they have over bonds in this respect. You may also notice that some preferred shares are categorized as cumulative versus non-cumulative. In the event the company has an issue making distributions those with cumulative shares would still be entitled to receive the missed payments at some point in the future, meanwhile those with non-cumulative shares would not be.
There is a lot to go into with preferred stocks, and before you purchase one you should definitely read that the prospectus to understand exactly how it works. Aside from the features that I mentioned some other things include the existence of rate floors, retractability features, and various term conditions which are important to understand.