Preferred shares are stock issued by a corporation that represents a claim on the assets. There are many types of preferred shares. They’re considered hybrid investment as they have equity and fixed income characteristics. In terms of equity characteristics, preferred shares trade on an exchange and have no fixed maturity. They’re noted down on the equity side of a company’s balance sheet. Fixed income characteristics include the fact that preferred shares pay fixed dividends, have a par value and carry no voting rights. Holders of preferred shares are prioritized over those holding common shares.
Types of Preferred Shares
There are various types of preferred shares, each structured differently. Below are the most common preferred shares that you might run into during your course of investing.
Rate Resets Preferred Shares
Rate Resets Preferred Shares are one of the most popular shares in the Canadian preferred shares market. Over 50% of preferreds are rate resets. These pay a fixed dividend rate until their reset date. The reset date is typically every 5 years.
When the reset date comes around, the issuer has the option to call the shares. If the shares are not called back by the issuer, a new a dividend rate will be locked in.
This fixed rate is usually based on the 5 year Government of Canada rates plus a premium. If an investor is not comfortable with a fixed rate, they can opt for a floating rate coupon.
These type of preferreds are popular as the investor has a predictable source of income.
Floating Rate Preferred Shares
Floating rate preferred shares pay a dividend where the rate is tied to a reference rate, usually Bank of Canada’s prime rate or Government of Canada’s 90 Day bond yield. The dividend payment would be adjusted at each payment date based on the reference rate. These types of preferred shares have a minimum dividend rate that investors might find attractive.
Perpetual Preferred Shares
Perpetual preferred shares pay a fixed dividend for as long as they’re in issuance. These type of shares have no maturity date but have a call date. The issuer can redeem or “call” these shares on or after the call date. When it comes to their duration, they’re similar to corporate bonds which is roughly 25+ years. However, the duration for banks are medium term in nature, 10 years.
Cumulative Preferred Shares
These types of preferred shares have a fixed cumulative dividend feature and paid out if or when declared by the Board of Directors. If no dividend is paid out in the quarter, the dividends accrue or accumulate to be paid in the next quarter.
Retractable Preferred Shares
Retractable preferred shares pay a fixed dividend. These types of preferred shares force the issuer to redeem the shares at par value on a specific date, if the holders opts to. There are two types of retractable shares. One forces the issuer to redeem the shares for cash and the other forces the issuer to redeem the shares in common shares.
Convertible Preferred Shares
Convertible preferred shares give the shareholder the option of converting it to common stock after a set date or on a specific date. These types of preferred shares are attractive to investors because the security that the fixed income dividend provides and the opportunity to gain from a rise in the share price.
Advantages of Preferred Shares
- Preferential Capital Structure – Preferred shares rank higher than common shares on a company’s balance sheet. Dividends on preferred shares have to be paid before common shareholders. This structure gives preferred shareholders a peace of mind.
- Known Dividend Rate – Unlike common stock that could experience a dividend cut, the dividends on preferred stock are determined when shares are issued. Certain preferred shares have cumulative features where any missed dividends accrue and must be paid on the next dividend date. Holders of preferred shares must receive their dividends before common shareholders.
- Tax Efficiency – Dividends from preferred shares have preferential tax treatment when compared to bonds. Bond interest is taxed at an investor’s full marginal tax rate but income from Canadian preferred shares is treated more favorably during tax time, thanks to the Dividend Tax Credit.
- Low Volatility – In normal market conditions, preferred shares tend to be less volatile than common stock but do have a higher volatility than bonds. An investor might find that preferred shares provide a more attractive risk/return profile compared to other fixed income securities.
