Preferred share selloff presents an opportunity to buy in at bargain prices and high yields

pref shares

Regularly, the investment environment goes a little nuts and offers up some particularly interesting investing opportunities. That is the case with preferred shares today.

Canadian Preferred shares are attractive investments for retirees as they are issued by blue chip companies (bank, insurance, pipeline, infrastructure), and provide guaranteed dividend income in a tax advantaged environment when held in taxable accounts. Even in registered accounts, the yields on preferreds today are almost twice as high as equivalent interest bearing investments. So even if the tax benefits are not applicable, the yields are still compelling. The following table summarizes the marginal tax rates for various types of investments by tax bracket in 2018. Remember that preferred shares pay dividends, not interest. These tax rates apply ONLY to Canadian dividends. US and other dividends are taxed at the same rate as interest or regular income.

Blog 2 Tax brackets

At the moment, many preferred share prices have been beaten down 10% or more since October, 2018. Initially, it was perpetual preferreds that got hit as investors felt that interest rates were headed up. Now it is the turn of floating rate and rate reset preferreds to get hammered, as investors have decided that interest rates are not going to go up in the foreseeable future. It doesn’t make a lot of sense that both types are down, and therein lies the opportunity.
There are basically three types of preferred shares:
Perpetual preferreds pay a fixed amount for the entire life of the shares, which has no termination date. They are supposed to act like long bonds and typically today yield between 4-6%, depending on the credit worthiness of the issuer. Big bank preferreds pay less, pipeline companies pay more and insurance companies are in the middle. Examples are:
Share     Current price     Yield at issue     Current yield     52 week hi/lo
CU.PR.E      21.27                     4.90                       5.76                       24.43/20.84
POW.PR.B  22.60                     5.35                       5.92                       25.29/22.25
RY.PR.H     18.98                     3.90                       5.14                       24.39/18.98
Floating rate preferreds set their rate every three months usually based on the Government of Canada 3 month treasury bill yield plus a % margin, typically 1.5% or more. So today these floaters are paying about 3.5% based on the issue price. But most are selling at a steep discount to their issue price and therefore yielding 5% or more. Example:
Share     Current price     Yield at issue     Current yield     Reset date     52 week hi/lo
FTS.PR.I   15.40                      2.10                       5.15                      Quarterly         19.41/15.04
Rate reset preferreds have a fixed rate for five years, and reset their rate every five years at a rate of Government of Canada 5 year bond rate plus a % margin which ranges from about 2% to 4.5%. A rate reset preferred resetting today would yield from 4% -5%. But again, these are selling at a steep discount to their par value (issue price) and thus generate a higher yield to those buying today. Example:
Share        Current price     Yield at issue     Current yield     Reset date     52 week hi/lo
IFC.PR.C     18.02                     3.30                        4.60                        12/2022           25.00/17.75
PWF.PR.T   19.46                    4.20                        5.26                         01/2019          25.35/19.41

The latest wrinkle is the minimum rate reset preferred. These reset every five years, but with a minimum guaranteed rate – usually the issue rate. That means that even if interest rates decline by the reset date, the investor still gets his/her rate that the shares were purchased at. Again, many of these are selling at a discount to their issue price, pushing up yields to the 5.5% range.
One caveat is that all preferreds have a recall provision, whereby the issuer can recall the shares on the five year anniversary by paying an agreed retraction price, although never lower than the issue price. However, if you buy shares below the issue price and they are retracted, you get your dividends up to the retraction date PLUS any capital gain for the difference between what you paid and the retraction price. This seems to me to be a pretty good deal as you have a guaranteed minimum dividend rate, no limit to the upside, and a potential capital gain if the shares are recalled. Note that almost all preferreds have an issue price of $25. Examples are:
Share    Current price        Yield at issue        Current yield      Reset date  52 week hi/lo
ENB.PF.I  24.20                        5.15                          5.32                         11/2021       25.95/22.66 G
Reset %: GoC 5 year + 4.14% (if reset today = 6.14%)
BIP.PR.D 23.12                         5.00                         5.47                          03/2022       25.71/22.11
Reset %: GoC 5 year + 3.78% (if reset today = 5.78%)

I like the last group as they offer the same benefits of a perpetual preferred (guaranteed yield), combined with protection against both interest rate increases and decreases, and the opportunity to make a capital gain.
Preferred shares can be difficult to buy as they are thinly traded (a few thousand shares a day) and the bid ask spread can be wide. In addition, they are complicated, as every issue (there can be multiple issues by companies per year) are likely to have different terms. To buy or sell them effectively, you really need an Online brokerage account where you can place Limit Orders at a price you determine, and sit back and wait to see if you can buy or sell at your price. It can take days to get an order filled at the right price.
Another alternative is to use a Preferred share ETF which tends to be more frequently traded and with narrower bid ask spreads. They do the decision making for you and while the yield will be lower because of the Management Expense Ratio (MER), the fees may be well worth it for the investor getting started in pref investing. Full disclosure – I own two ETFs listed below (HPR and ZPR) as well as several individual preferred shares.
The two are:
ETF       Type                           Price      MER     Current yield     52 week high/low
HPR   Actively managed       8.12          .63          4.45                      9.89/8.00
ZPR   5 year ladder resets    10.02        .50          5.01                      11.97/9.80

Talk to your financial advisor or conduct thorough due diligence to see if preferred shares are right for you. They may be a good alternative to bonds to help balance your portfolio and provide a sustainable source of tax advantaged income through what seems to be a volatile investing environment for the foreseeable future. At this point in the market, there is no need to buy preferred shares that are selling for more than their issue price, in order to maintain access to potential capital gains should the prefs be recalled.

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