A basic primer for bonds and preferred shares

The bond market is the largest securities market in the world. High quality bonds provide investors with low-risk income. And ‘laddering’ your portfolio lets you match maturity dates to your ongoing cash requirements. Preferred shares are a hybrid security occupying a place between bonds and common shares. They are senior to common stock but rank behind debt-holders’ claims.

What you need to know about bonds

How to buy a bond. Ask these five questions:
• What’s the bond’s price? Your broker will quote a price per $100 of par value. Most investment dealers sell bonds in quantities as low as $1,000 of par value. Instead of charging you a commission, they build their profit into the price of the bond.

• What’s the total cost? You pay the seller for interest that has accrued since the last interest payment. (You get this interest back with the next interest payment, along with the interest you’ve earned since you bought.)

• What’s the yield to maturity? This takes into account the gain or loss at maturity, if you buy at a price other than par value.

• How much of the gain is tax-free? If you buy a bond below par, any capital gain you make qualifies for favourable tax treatment. Only 50 per cent of the capital gains are taxable.

• Can I get a better price? If the yield sounds low, ask your broker if he can give you a better price. Or, try another broker. It always pays to comparison shop.

What you need to know about preferred stocks

• The dividend tax credit makes $1 of dividends equal to well over $1 of interest income for most taxable Canadian investors. Even U.S.-dollar dividends paid by Canadian firms get this tax credit.

• You only get preferred dividends when the company’s directors feel the company can afford to pay. But a company has to pay all preferred dividends before common shareholders get anything. Dividends are riskier than interest because companies can stop paying dividends without risking bankruptcy.

• A company must pay off all cumulative dividends—or ‘dividends in arrears’—before it can resume paying common dividends.

• Floating-rate preferreds pay a dividend that varies with the banks’ prime lending rate.

• Redemption is the company’s right to buy your preferred shares back at fixed times and prices. Most preferreds are redeemable. If you buy above the redemption price, remember you could lose some of your capital. If preferreds trade below their redemption prices, you could earn capital gains. Keep the yield-to-call in mind.

Preferred securities and preferred split shares

• Preferred securities are unsecured junior subordinated debentures. They are hybrid investments, meaning they have characteristics of a bond and preferred share.

• Like bonds, the payments you receive are 100% taxable. Preferred securities also have a maturity date (usually 49 years from the date of issue). They rank ahead of preferred shares in bankruptcy.

• Like preferred shares, preferred securities have a $25 par value and trade on the stock exchange.

• The issuing company has the right to defer interest payments at any time for up to 20 consecutive quarters. Interest accrues but will not compound. Preferred securities are redeemable five years following their issue.

• Split share corporations are created to hold one or more common shares, called portfolio shares. Portfolio shares are artificially split into preferred shares and capital shares.

• Preferred split shares receive all the dividends from the portfolio shares. Typically, it means the dividend yield will be twice the yield of the portfolio shares.

• Split shares have an annual retraction date when the company buys back a certain number of shares. There’s also a final redemption date when all the preferred split shares are redeemed.

• Preferred split shares may be redeemed for less than par value if the portfolio shares drop below the par value of the preferred split shares.

 

This is an edited version of an article that was originally published for subscribers in the December 16, 2016, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846