Yikes! What Has Happened To My Preferred Shares?

When the Bank of Canada dropped its overnight lending rate by a quarter percent in January 2015, the markets were caught off guard. Consensus had been that the US Federal Reserve would raise rates in 2015 and that the Bank of Canada would follow suit. Expectations for rate increases had been factored into the markets. Seeing the impact of falling oil and raw materials prices on the Canadian economy, the Bank of Canada decreased its overnight interest rate in an effort to provide some stimulus to the Canadian economy. The added incentive, though not stated, was that a rate cut would instantly weaken the Canadian dollar, giving a boost to exporters. Then in July, with data showing the Canadian economy as an aggregate was possibly in a technical recession, the Bank of Canada cut the overnight rate by another quarter percent.  

Investors do not like surprises but the market values of pure floating and reset preferred shares fell in some cases by approximately 30% in the past year. Many preferred shareholders opening their investment statements were shocked and bewildered. They had numerous questions for their investment advisors. How could this be? I thought these were safe? What do we do now?

Why Preferred Shares In A Portfolio?

The low-interest rate environment we have experienced for the last several years presents challenges for the investor who seeks a low-risk investment portfolio that will produce sufficient income to meet his or her lifestyle needs. Bond yields of 1% to 3% are barely keeping pace with inflation, and produce fully taxable interest income (when not held in an RRSP or other tax deferral plan). Equity markets are often seen as too risky for the low-risk investor, and therefore equities often form only a small part of the investment portfolio. Investors and their advisors have sometimes turned to preferred shares of Canadian companies to enhance yield in the investment portfolio at risk levels acceptable to the investor.

While each preferred share has its own unique characteristics, most can be classified as pure floating, reset, retractable, straight or structured. Two of the major classes—pure floating and reset issues—pay a dividend based on current, short-term interest rates. Most use a Bank of Canada benchmark (90 day T-Bill in the case of pure floating and, in the case of resets, the five-year Government of Canada bond) with the dividend tied to the rate. Pure floating issues normally have the dividend adjusted every 90 days while reset issues typically are adjusted every five years.

Because their dividend rates are adjusted upwards should interest rates rise in the future, pure floating and reset preferred shares can provide some stability to the portfolio in an environment of rising interest rates. On the other hand, if interest rates fall, the reset will continue to provide the fixed premium over the prevailing rate and, relative to equivalent fixed-income alternatives, maintain an advantage in yield spread. Theoretically, one would assume very little price volatility associated with these securities, making them appealing investments for the low-risk investor looking for reasonable levels of income. But that certainly wasn’t the case in 2015 as volatility was abundant in the reset and floater issues.

Now What?

The deep discounts the market has imposed on these issues could well be an overreaction. Certainly a cut in the Central Bank’s overnight lending rate could result in lower income upon the resetting of dividends. But, many analysts have insisted that it does not warrant the price declines these securities have undergone in 2015. It would appear the market either sees a long extended period of low interest rates or continued uncertainty regarding the direction that interest rates will take in the near term. One also has to wonder if the credit-worthiness of issuers is being called into question by investors.

Investors who have realized capital gains for tax purposes in recent years may want to sell some of their preferred share holdings to incur a loss that can be used to reduce taxes paid in previous years. Losses need to be harvested before the end of each calendar year, whereas in corporate accounts the deadline is the fiscal year-end. With the proceeds from the sale, consider purchasing similar preferred shares (proxies) to avoid holding cash for 30 days to abide by the superficial loss rules. These securities continue to see significant price swings from day to day so an investor may want to avoid sitting on the sidelines for a month and potentially miss out on a rebound in price.

It is important to keep in mind that these securities continue to pay healthy dividends while we wait for share prices to recover. In some ways I liken this to a situation where your rental property has declined in price but the tenant continues to pay you a healthy rent cheque. You get paid while you wait. Remember, the objective for purchasing preferreds in the first place was for a steady stream of tax advantaged income. If you are dependent on your portfolio for income, I would hope your strategy includes a cash reserve to satisfy your short-term capital draw-down requirement (in the event that income alone is not sufficient to cover cash flow needs). Never buy preferred or common shares if you need to dip into this capital in the short term.

In fact, many analysts who carefully follow the preferred share space feel that current prices provide investors with excellent yields at bargain prices the market has not seen for quite some time. Many issues are currently yielding in the range of 5%, which, when held inside a non-registered or corporate account, receive preferential tax treatment which translates into a pre-tax interest equivalent yield of approximately 6% depending the investor’s tax bracket. Although the objective of preferred shares is income, not capital gains, some investors feel there may be an opportunity at this time to take advantage of this depressed asset class. Idle cash could be deployed and for those who have a higher risk threshold, a leveraging strategy might be considered. Borrowing rates are low and the yields even on an after-tax basis should cover and even exceed the cost of borrowing based on today’s borrowing rates when tax deductibility is factored in.   The patient investor is left with an investment that carries itself from a cash-flow perspective and provides capital gains potential that typically isn’t the objective. I am the last person to encourage leveraging, but it could make sense in certain circumstances. We must be mindful however that companies could cut their dividends or, worse, default on the repayment of your capital. Also, in the short term there could be further downward pressure on the prices of pure floaters and resets as the Bank of Canada hints at additional rate cuts.

It is imperative to consider any change to your investment strategy in the context of your overall financial plan, one that considers your rate of return requirement and willingness to take risk.

Full disclosure:

I personally hold these types of securities in my portfolio, however, every situation is different, so I encourage you to seek advice from your integrated team (financial planner, investment specialist and accountant working in collaboration) to determine what is the best course of action for you.

Ross McShane, CPA, CGA, CFP, RFP, CIM , Director, Financial Planning, McLarty & Co Wealth Management, Ottawa, Ontario (613) 699-6868 www.mclartywm.ca.