PETER DOLEZAL: The magic of preferred shares

Preferred shares are a hybrid; they are part equity, part debt

Most investors think of a Fixed Income holding as either GICs or Bonds. Few realize that carefully-selected preferred shares can be a far superior form of fixed income, both from the perspective of not only generating a higher income stream (yield), but also on a much more tax-efficient basis.

Preferred shares are a hybrid; they are part equity, part debt. While they rank behind bonds on the credit spectrum, they rank ahead of common stock — hence the name “preferred”.

A preferred shareholder has an ownership interest in the company issuing the shares; unlike a common shareholder however, he has no voting interest.

On the other hand, the preferred share, unlike the common share, offers a pre-specified dividend yield —always higher than that of the same company’s common shares. The issuing corporation is obliged to discharge all of its dividend obligations to preferred shareholders before paying any dividends to common shareholders — again emphasizing the former’s “preferred” status.

Aside from their higher yield, preferred shares held in non-registered accounts are subject to a much lower tax rate on dividends than is the case with interest paid on bonds or GICs.

In British Columbia for example, an individual in the highest marginal tax rate will pay tax at a 45.8 per cent rate on interest income, while paying only 28.7 per cent on dividends received from listed Canadian corporations.

Even more dramatically, if the taxpayer falls below $44,000 in total annual income, any eligible dividends earned as part of that income will attract zero tax. At an income of $44,000, interest income, by contrast, would attract a tax rate of 29.7 per cent.

This combination of higher yield and lower tax rates makes Canadian preferred shares a very attractive alternative for investors, especially in non-registered accounts.

As with all investments, there is always reason for caution. Preferred shares held in only one or two corporations should not be considered as a prudent fixed-income investment, any more than would only one or two corporate bond holdings.

However, when a broad spectrum of preferred shares is held (in perhaps one hundred or more individual corporations), sufficient diversification is achieved for that holding to be considered as fixed income.

About a dozen Canadian preferred share Exchange Traded Funds (ETFs) meet this broad diversification test; they are offered primarily by i-Shares, and the Bank of Montreal.

As with bonds, preferred share capital values will fluctuate over the short term with rising or falling interest rates, but over the long term, they should provide a total annual return average superior to most GIC or bond options.

Similar to laddered bond ETFs, preferred share ETFs which offer one-to- five year laddering are available, providing longer-term participation in future interest rate increases.

Today’s Canadian preferred share ETFs offer dividend rates in the range of 4.25 per cent to 4.75 per cent.

Every investor holding fixed income in his/her portfolio should consider including a broadly–diversified preferred share component, for at least the non-registered holdings.

 

A retired corporate executive, enjoying post-retirement as an independent Financial Consultant (www.dolezalconsultants.ca), Peter Dolezal is the author of three books, including his recent Second Edition of The SMART CANADIAN WEALTH-BUILDER.