Preferred Shares

Source: Canadian Wealth Advisor January 2003

Insiders guide to preferreds.

Preferred shares can offer investors a better after-tax yield than bonds, while being close in security to bonds.

There are two main differences between bonds and preferreds: security, and the tax treatment of bond interest versus preferred share dividends.

Dividends come with a credit.
Dividends paid on preferred shares are treated identically for tax purposes as dividends from common shares. So indicated dividend yields on preferred shares are actually even higher when you factor in the Canadian dividend tax credit. The dividend tax credit makes dividends from eligible Canadian companies worth around one-third more, after tax, than the same amount of interest income.

For example, an investor in the 50% tax bracket would pay 50% tax on interest income. Canadian dividend income, after factoring in the dividend tax credit, would be taxed at only around 33%. That means that a preferred share yielding 5% is equivalent, on an after-tax basis, to a bond yielding 6.7%.

Investment quality provides security.
Preferred shares have a prior claim on a firm's assets over the common shares, in the event of the winding up or the dissolution of the company. However, preferred shares rank behind creditors and bondholders. that's why when evaluating preferred stock, an issuer's creditworthiness is of prime importance. When you buy bonds, it's best to stick with high-quality government bonds, and avoid higher-risk corporate bonds. When you invest in preferreds, choose bank or utility company preferreds, rather than higher-yielding preferreds from riskier firms.

Preferred shares are usually entitled to a fixed dividend. However, unlike bond or debt interest, a firm's board can vote to not pay preferred dividends. But they usually have to suspend common dividends first. Again, stick with the highest quality preferreds.

Special features.
Callable or redemption feature: Preferred share issuers often have the right to call or redeem preferred issues. This is an advantage to the issuer. Usually the terms provide for a small premium over the par value of the shares.

Retractable preferreds: The preferred shareholder can force the company to buy back the shares on a specified date at a specified price.

Cumulative feature: If a company's board votes to not pay preferred dividends, then the unpaid dividends accumulate in arrears. All arrears must be paid before common dividends are resumed or the preferred shares are redeemed.

Non-cumulative feature: Non-cumulative preferred shares are entitled to dividends only when declared. Skipped dividends do not accumulate in arrears. However, common dividends have to end before companies cut preferred dividends.