This week's questions revolve around the preferred share asset class. Like many investment classes over the past few months, preferred shares have seen significant declines. However, the mechanics behind how preferred shares trade are somewhat different from common equities and other similar investments. Today's post will review preferred shares as an asset class, their unique characteristics and recent performance. Our follow up post will discuss a specific subset of preferred shares, the reasons for their underperformance and the outlook going forward.

 

Q. What has happened to preferred shares? (Part One)

 

Preferred shares are an interesting financial instrument. They have characteristics of both bonds and equities and occupy a sort of financial no-man’s land in between those two better known asset classes. Like common shares, preferred shares trade on stock exchanges and are considered equity investments. The income received from preferred shares is considered a dividend, meaning that it receives preferential tax treatment due to the dividend tax credit. This is particularly useful if you want to generate income in a non-registered, or taxable, account.

 

Like bonds, preferred shares are issued at a par price (typically $25.00 per share) and can be called (bought back) at that price by the issuing company later. Also, like bonds, the primary reason to own a preferred share is its income stream. Preferreds are issued with a predetermined dividend rate that is preferential to common share dividends. What this means is that a company is required to pay out its preferred dividends before any common shareholders can receive their payments. This makes the income stream from preferred shares more stable than that of common shares, and this can be quite appealing to income focused investors.

 

Recent Declines

 

Over the past few months the share prices of many preferred shares have declined. This can be disconcerting for investors who added preferreds to their portfolio as a relatively stable source of income. While there can be company specific reasons leading to an individual preferred share declining, when the entire asset class moves as it has in recent months, it is usually one overriding concern that can be pointed to as the cause of the decline: interest rates.

 

Interest Rate Sensitivity

 

We looked at the shared characteristics of bonds and preferred shares a few minutes ago but did not touch on one of the main similarities. Like bonds, preferred shares are sensitive to interest rates. Typically, when interest rates rise, bond prices fall, and vice versa. This means that in an environment where interest rates are declining, the price of a bond will usually rise, giving its holders a nice capital gain to go along with their income stream. Perpetual preferred shares, one of the sub classes of preferred shares, act in a similar manner. When rates go up, perpetual preferreds should see their share prices decline. When rates go down, the opposite happens. Recently, as part of the response to the COVID-19 pandemic, central banks around the world have significantly decreased interest rates, which should be considered positive for perpetual preferreds. Why then, has the preferred index declined?

 

To answer this question, we will have to explore a subset of the preferred share universe called fixed reset preferreds. We will cover that in our next post, along with our thoughts on the outlook for the asset class and what to do with your existing preferreds. Until then, stay well and if you have any questions you would like to see answered in a future post, please send them to us at the email below.

 

Andrew.Czernik@cibc.ca

 

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