Noise Reduction Strategy Part 2: Dividends and Preferred Shares

Scott Hanson Preferred shares are often overlooked and underutilized in portfolios. Preferred shares are dividend investment niches as they occupy a relatively smaller corner of the investment market, given they have limited volumes compared with common shares. Although preferred shares trade on major exchanges, such as the TSX, they generally do not correlate with the performance of the underlying issuer’s common stock as they are not part of the company’s equity capital. Preferred shares can offer generous dividends, as long as investors understand the characteristics and aspects that are unique to each type of preferred share and issuer. There are three types of preferred shares in Canada:

Perpetual: The dividend is fixed for the term of security. The term is confirmed by the issuing company.

Floating rate: The dividend is adjusted quarterly, based on prevailing interest rates.

Fixed-reset: The dividend is fixed for five years from issuance and reset for each subsequent five-year period, based on the five year Government of Canada (GoC) yield. It could also be converted at that time into a floating rate issue, based on shareholder demand at the time of reset/conversion.

Preferred shares’ performance depends on several factors. Investors may want to consider the following when purchasing Canadian preferred shares:

Interest rate outlook (different types of preferred shares are affected differently).
Preferred shares demand.
Corporate bond yield spreads over government bonds.
Current market volatility, trading volume and liquidity.

Similar to common share dividends, preferred dividends are paid at the company’s discretion and can be suspended by its board. If the preferred share issue is cumulative, those unpaid (arrears) dividends accumulate until the company can or is allowed to reinstate the preferred dividends. As a general rule, non-bank-issued preferred shares are cumulative, however you must always check to make sure. The preferred share market lacks the liquidity of equity markets so investors need to exercise an extra level of care, knowledge and execution in the selection, purchase and sale of these securities.

Fixed-Reset Preferreds Can Balance Stability and Future Rates

Fixed-reset preferred shares offer a balance between a fixed rate and a floating rate. The rate is issued within its regular five year resets, providing a partial inflation/interest rate hedge and, to a degree, mitigating capital losses that would be experienced by securities that are more vulnerable to higher interest rates. Many recently issued fixed-reset preferred shares have a minimum rate reset feature should the five year GoC bond yield decline over the five-year lock-in period.

For example, a company might issue a fixed-reset at 5.5%, with a minimum rate reset yield floor of 5.5% based on par value. What this means is that regardless of the five year GoC yield on bonds, the company will not reset the yield below 5.5% and thus provides holders with a 5.5% minimum yield. Of course, the yield based on par, could be higher based upon the five year GoC and the reset features at time of reset; however, the reset yield based on par will never be lower than that minimum reset feature. This extra feature provides the investor with a minimum yield on reset, which would give that preferred share increased stability versus fixed-reset preferred shares which lack the minimum reset feature.

As an example, if that particular preferred share had a par value of $25.00, currently trades at $18.00 and was recently reset at 5.5%, the new annual dividend would be 0.055 X $25.00 (par value) for a yield of 7.6% ($1.375/$18.00). It is important to note that the dividend reset is always based upon par value, not the current prices, so if the current price of the preferred is below $25.00, the yield you would receive for purchasing shares would be higher than the reset yield.

Window of Opportunity for Fixed-Reset Preferred Shares?

In the chart below, the spread between the yield on the S&P/TSX Preferred Share Index and the five year GoC bond yield has widened significantly over the past year resulting in preferred shares trading at lower prices in contrast to bonds on a relative basis. Over the past 10-year period, the spread widened the most in January 2016 when the preferred share market was impacted by similar factors that are currently present such as: slowing global growth, falling rates and geopolitical concerns. The recent peak versus bonds was not as dramatic as 2016, but it has created potential opportunities for investors. Take for example a five year GoC bond which was approximately yielding 0.57% the last time the yield differential peaked. The difference is almost one per cent lower than its current yield. In other words, the same preferred share re-setting today could receive a dividend $0.50 higher than if it had reset a year ago at the lower GoC bond yield.

It takes careful consideration to build a portfolio that represents your unique goals and risk tolerance—just like understanding which preferred share might be suitable for you. While preferred dividend securities might not provide the growth that some investors are seeking, they can provide additional income through dividend payouts. These securities can provide capital for re-investment, additional income and act as a cash cushion in times of heightened market volatility.

Scott Hanson is an Investment Advisor with CIBC Wood Gundy in Barrie. He and his clients may own securities mentioned in this column. The views of Scott Hanson do not necessarily reflect those of CIBC World Markets Inc.

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2019

Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.