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Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
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  • 1.800.230.5544
  • F613.237.5949
  • 265 Carling Avenue,
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  • Ottawa, Ontario K1S 2E1

Preferred Shares: Not worth the risk in non-taxable accounts

February 2, 2015 - 2 comments

Investors looking for yield in a low-interest rate environment will often turn to preferred shares. Preferred shares can be a good tool for taxable investors due to the Canadian Dividend Tax Credit, but for non-taxable investors they are significantly less attractive. In situations where tax efficiency is not a benefit, preferred shares pose risks that are not worth taking.

Like bonds, preferred shares are exposed to credit risk. An important difference between the two types of securities is that in the event of a bankruptcy/reorganization, preferred shareholders are the last to be paid after all creditors. Preferred shares also have a higher risk of default than bonds from the same issuer; this is because firms are generally allowed to default on their preferred dividend without defaulting on their bond interest payments. In the event of a general payment default, preferred shares are unlikely to recover any of their initial investment, whereas bondholders typically recover 20 to 60 cents on the dollar. These factors make the credit risk associated with preferred shares much higher than that of bonds.

Preferred shares can also be exposed to redemption risk; they are often redeemable at the option of the issuer. This means that the issuer can choose to buy the shares back from investors at a fixed price according to a pre-set schedule. The result of this redemption option is that if interest rates go up, you are stuck with your relatively low dividend preferred shares, and if rates go down you won’t benefit much from price appreciation. The price of a redeemable preferred share does not rise on falling interest rates like that of a bond because the market knows that if the price rises past a certain point, the company will take the preferred share back at the predetermined price.

To justify their level of risk, preferred shares would need to offer significant return. The S&P/TSX Preferred Share Index, as of Dec 31 2014, has returned 4.6% over 5 years and 2.9% over 10 years. Preferred shares do not offer sufficient return to make them an attractive option for non-taxable investors.

By: Ben Felix & Raymond Kérzerho with 2 comments.
Comments
  06/07/2015 9:47:07 AM
Benjamin Felix
@Eric this question cannot be answered without knowing more about you and your situation, but there are some basic guidelines on page 10 of this PWL white paper: https://www.pwlcapital.ca/pwl/media/pwl-media/PDF-files/White-Papers/2015-02-20_PWL_Kerzerho-Bortolotti_The-Role-of-Preferred-Shares-In-Your-Portfolio_Hyperlinked.pdf?ext=.pdf
 
  03/07/2015 8:28:20 AM
Eric
What percentage of preferreds in a portfolio would you recommend for a long term buy and hold investor that needed to allocate funds to taxable accounts?
 



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