Why I Prefer to Avoid Preferred Shares | Common Sense Investing


This is the second video in a multi-part series
about alternative investments. In the first video in this series, I told
you why high-yield bonds fall short on a risk adjusted basis, and should only be included
in your portfolio in small amounts through a well-diversified low-cost ETF, if at all. If you haven’t watched it yet, click here. And BTW, I do not recommend high yield bonds
in the portfolios that I oversee. Alternative investments are generally sold
on the basis of exclusivity to wealthy individuals. Warren Buffett said it best in his 2016 letter
to shareholders: “Human behavior won’t change. Wealthy individuals, pension funds, endowments
and the like will continue to feel they deserve something “extra” in investment advice.” In addition to high yield bonds, income-seeking
investors may turn to preferred shares. Preferred shares typically offer higher yields
than bonds. They also have some tax benefits for Canadians
who own Canadian preferred shares. While these benefits are attractive, preferred
shares also come with additional risks and complexity that bonds do not have. Remember, risk and return are always related. I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of common sense investing
I will tell you why I prefer to avoid preferred shares. Preferred shares are equity investments in
the sense that they stand behind bond holders in the event of bankruptcy. In a bankruptcy, debt holders would be paid
first, followed by preferred shareholders, and then finally common stockholders. Typically, preferred and common shareholders
will receive nothing in a bankruptcy. Where preferred stocks differ from common
stocks is that they do not participate in the growth in value of the company. The return on preferred stocks is mostly based
on their fixed dividend. Unlike a bond, preferred shares do not generally
have a maturity date. This makes them effectively like really long-term
bonds. Unfortunately, fixed income with long maturities
tends to have poor risk-adjusted returns. Long-term fixed income also exposes you to
a significant amount of credit risk. Can the issuing company pay you a dividend
for the next 50 plus years? Like a bond, if interest rates fall, the price
of perpetual preferred shares can increase. While this sounds good, the problem is that
perpetual preferred shares typically have a call feature. If interest rates fall too much, the issuer
will redeem the preferred shares at their issue price. The same thing can happen of the credit rating
of the issuing company improves, allowing it to issue new preferred share or bonds at
a lower interest rate. This creates asymmetric risk for the investor. They get the risks of an extremely long-term
bond, but have their upside capped. One of the most common types of preferred
shares in the Canadian market are fixed reset preferred shares. These have a fixed dividend for 5-years, which
is then reset based on the 5-year government of Canada bond yield plus a spread. Investors are able to accept the new fixed
rate, or convert to the floating rate. This process continues every 5-years and helps to reduce interest rare risk. In 2015, rate reset preferred shares dropped
in value significantly, causing the S&P/TSX Preferred Shares index to fall 20% between
January and September 2015. Preferred shares have some other characteristics
that make them risky. A company is usually issuing preferred shares
because they want to raise capital but are not able to issue more bonds. This could be because they can’t pile any
more debt onto their balance sheet without getting a credit downgrade. Companies also have a much easier time suspending
dividend payments on preferred shares, which they can do at their discretion, than they
do halting bond payments, which would mean bankruptcy. These characteristics might cause an investor
looking for a safe asset to think twice. Enough negativity. Why does anyone invest in preferred shares? I’ve already mentioned the higher yields
that preferred shares offer compared to corporate bonds, making them attractive to an income-oriented
investor. Canadian preferred shares also pay dividends
that are taxed as eligible dividends in the hands of Canadian investors. This might make preferred shares a good candidate
for the taxable account of an investor that pays tax at a high rate. Preferred shares do also have returns that
are imperfectly correlated with other asset classes, meaning that there can be a diversification
benefit to including them in portfolios. So, should you invest in preferred shares? For their few benefits, preferred shares have
substantial risks. In Larry Swedroe’s book The Only Guide to
Alternative Investments You’ll Ever Need, he writes that “The risks incurred when
investing in preferred stocks make them inappropriate investments for individual investors.” I do not recommend preferred shares in the
portfolios that I oversee. In a 2015 white paper my PWL colleagues Dan
Bortolotti and Raymond Kerzerho recommend that if you are going to invest in preferred
shares, you should only use them in taxable accounts, limit them to between five and fifteen
percent of your portfolio, and diversify broadly. They also emphasize that you should avoid
purchasing individual preferred shares due to the complexity of each individual issue. Join me in my next video where I will take
a break from this mini-series on alternative investments to tell you why income investing
doesn’t really increase your income. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe and click the bell for updates. I want these videos to help you to make smarter
investment decisions, so feel free to send me any topics that you would like me to cover.

Paul Whisler

12 Comments

  1. Everything what you say here is absolutely correct and makes sense. Thank you, Rustam

  2. Very true, every time I think of buying a preferred share in a company because it's trading at a significant discount to its par value/call price, I just remind myself that the company is never, err.. perhaps I should say very rarely, for compliance reasons, under any obligation to call/redeem its preferred shares.

    If I were going to invest in a small amount of preferred shares, I think 5% of one's overall portfolio probably makes sense (I'd go 10% as the upper end of the range, though, not 15%), I'd probably just go with Horizons' Active Preferred Share ETF (HPR).

    Also, your point that a company often issues preferred shares when it needs capital and is over-levered is a good one. I should apply the similar discipline to the above by avoiding companies like Element Financial, which may be attractively valued on a P/E basis, not so when looking at its balance sheet, and simply avoid it entirely* (*well, to the extent possible, it's going to exist in a very, very small way in a passive index fund).

    Cheers,
    Doug

  3. Doesn't the rate reset on the Canadian shares substantially decrease the interest rate risk? What if I buy shares that will reset every year (think of the zpr etf or a strategy that yields similar results) also, I like their complexity, the fact that fewer people bother with them makes them attractive in certain opportunities. Consider 5 year rate reset shares trading at around half their call values now. In 5 years and every year thereafter they could reset to double the intended rate from our perspective…At worst these shares help shield us from a situation where interest rates increase a lot and we had bought them in a less favorable environment. And not everyone likes to bother trying to predict the future with common stock :/

  4. But if there can't be a payment, they are obligated to pay us back, and shares get sold automatically instead of losing their value.

    Seems like a good deal to me.

  5. I prefer to avoid sharing my joint as I smoke and watch your informative vids good sir, lest I become distracted by banalities of frivolous non financial discussions

  6. Don’t they historically return better returns then bonds do? Index wise. Wouldn’t you get a greater long term return with perfereds then bonds I deal with taxable accounts only.

  7. Nrz is getting a preferred stock. Will this devalue the common stock?

  8. With all due respect Ben, you are wrong on this. If you read any authors on SeekingAlpha.com, such as Colorado Wealth Management, Brad Thomas, Scott Kennedy, and others, you will see that there is indeed a very successful method for picking and holding preferred shares. If the parent company is stable, then the risk to the principle is minimal. Also, the preferred share price fluctuates generally within a narrow band. Yes, some go down, and some go up.

    In 2012, as my parents became retirees, they needed to depend more on dividend income. However, their nestegg (Roth IRA/Trad IRA/Rollover IRA accounts) only came up to $180K USD. So, what do you do? Most "Financial Advisors" (I was a series 7 at Merrill Lynch) would sell them a "Safe" Fixed-Index Equity Annuity…the principle is safe but the returns are peanuts. OK, so then what…how about ETFs…say the S&P500 ETF…sure it has gone up, but it doesn't produce quarterly cash in the pocket (which is the goal for non-rich retired folk). OK, so how about some mutual funds? Yeah, they also don't produce cash in hand.

    And then comes in the star of the show: preferred shares. Nice ones paying 7%-9% yield…my parents have had them for years and NOT ONE has cut or suspended dividends, and only one has been called, at a profit actually.

    It is painfully obvious watching this video that you don't know what the hell you are talking about. Cheers.

  9. First: Mr. Felix, I only just discovered this YT channel, and I am greatly impressed with your presentations. You do a yeoman's job of breaking down complex financial matters into simpler components, thus making every concept you discuss very accessible for the layperson. Kudos!

    Regarding preferred specifically:

    I've done very well with pfds. Though I confess, I don't anticipate keeping them as a permanent part of my portfolio. A couple comments addressing the criticisms put forward by Mr. Felix..

    As preferreds are equity, its true that in the event of a bankruptcy, pfd holders may get nothing. Well, yes, but that same argument can be said of common-equity too.

    As to issuers being able to halt pfd divd payments, well, I generally ONLY purchase pfds of very substantial, and investment-grade (by Moodys) institutions. In the U.S., these would include the big banks, A-rated insurance companies, and utility firms. In fact, rather than "diversify widely" among preferreds, I much prefer to concentrate my pfd holdings in quality firms — avoiding financially weaker firms altogether.

     In the US, ANY halt by a company to paying pfd stocks, the company's BOD would first be required to halt all payment on its common shares. — Any plausible rumors to common divids being halted would weigh heavily on the price of common shares — which would be the "tell" for a pfd shareholder to sell his shares long b4 any unfavorable action on the pfds would occur.

    Its true that pfds have "call risk". When called, the issuer would redeem shares at "par value". That amount is a known value (often $25/share in the U.S., though each security is different). Since par- or redemption-value is known, as is the date when an issue can first be called, I make it a practice to only buy an issue below or near par-value, and with years before the pfd is eligible to be called.

    Thus, buying pfds ONLY from quality issuers (selling those pfds, if the issuer quality deteriorates), and paying only par-value (or less) effectively removes credit- and call-risk. What's left is interest-rate risk. That IS a real-risk. As long-duration instruments, I would certainly recommend exiting/avoiding preferred altogether if there is any hint of a material rise in interest rates. Of course, a material rise in interest rates would also be a great reason to avoiding conventional bonds and common equities too…

  10. Hi can I know what do you invest in? do you just invest in common stocks?
    thanjks

  11. I do not recommend the Canadian preferred ETF, I think it would be better to hand pick 4 to 6 different companies preferred to have as a minor (10% to 20% holding) in a portfolio. The etf is too hard to understand, but 4 or 5 issues one can understand, minimum rate resets or perpetual discounts or a rate reset that is priced low enough to act as a good hedge against a potential rise in rates…

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