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Preferred shares still offer value

Preferred shares have fared well for nearly two years now. But we believe there is still room for further gains ahead.

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BCE’s fixed floater preferred is due to reset its dividend in 2023. This could be good for the shares if interest rates are higher by then.

The S&P/TSX Preferred Share Index is up 72 per cent from the low it reached in March 2020, when the coronavirus caused a widespread meltdown in financial assets. But though they have enjoyed a strong recovery since then, we believe there’s room for further gains ahead. Mind you, gains will likely be more subdued, perhaps in the low-to-mid-single-digit range this year.

Preferred shares have a long and complex history as securities of choice for investors seeking income. They began as a way for investors to trade potential for higher current income. They represent equity, or ownership, as opposed to debt. But they rank ahead of common shareholders in almost all respects. Preferred shareholders must, for example, receive their stated dividend (often including any arrears) before the company pays any dividends to common shareholders.

In other words, if a company has been paying generous dividends to common shareholders, the preferred shareholders might see that as a cushion. In a cash squeeze, the company can cut out the common-share dividend before cutting preferred dividend payments.

Also, in the dissolution of a company, due to, say, bankruptcy, preferred shareholders must be paid the par value of their shares and usually any unpaid dividends before common shareholders get anything.

Over the years, issuers and buyers of preferred shares have enjoyed special covenants attached to the shares that benefit one or the other. Redemption, retraction, and cumulative dividends name most such features.

Many investors and advisers often point out further that the dividends paid on Canadian preferred shares qualify for the dividend tax credit, making them more valuable than comparable interest yields and better suited to non-registered accounts than registered accounts.

Rate-rest preferred shares are the most common type of preferred shares in today’s markets. They typically reset their dividend amounts every five years according to a specified spread based on the yield of the five-year Government of Canada (GOC) bond. Given that bond yields are expected to move higher in coming years, these shares may do well. For exposure to rate-resets, consider investing in the BMO Laddered Preferred Share ETF (TSX—ZPR).

Floaters look good too

Another type of preferred share that responds well to rising interest rates is floating-rate preferreds. These issues work much like rate-reset preferreds, except changes in their dividends are based on fluctuations in the Bank of Canada’s overnight interest rate target. Changes in this rate usually lead to similar changes in the prime interest rate charged by Canada’s banks. And floating preferreds typically change their dividend payments based on a specified percentage of the prime rate.

As the Bank of Canada will likely continue to raise its overnight target in coming months, floaters will do likewise with their dividend payments. This should provide some support for their share prices.

Straight preferreds that pay fixed perpetual dividends, on the other hand, are vulnerable to rising interest rates. That’s because their fixed dividends become less attractive, and this may result in some selling pressure.

Among the straight preferreds in our Fact and Advice Sheet, we include two fixed floaters. Of the two, BCE Inc. (TSX—BCE.PR.C) is due to reset its dividend in 2023. And this could be good for the shares if interest rates are higher by then.

This is an edited version of an article that was originally published for subscribers in the March 18, 2022 issue of Money Reporter [2]. You can profit from the award-winning advice subscribers receive regularly in Money Reporter. [2]

Money Reporter [2], MPL Communications Inc.
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