Beware the trap of high-yield preferred dividend stocks

Some income-seeking investors are turning to preferred dividend stocks to increase the cash they earn. But this can cost them money if they ignore the yield-to-call on older preferreds.

Some income-seeking investors are turning to high dividend paying preferred stocks, as an alternative investment to common shares, to increase the amount of cash they receive. All too often, however, they end up earning far less than they expected—or even losing money. That’s because they fail to pay attention to the ‘yield-to-calls’ of their preferreds.

It’s important to distinguish between a preferred share’s current yield and its yield-to-call. The current yield, of course, is the dividend divided by the share price. The yield-to-call is a smarter way to evaluate a preferred. It asks: “If the company calls in and redeems my preferred shares, what yield will I earn?”

When interest rates fall, the prices of fixed-income investments—such as bonds and preferred dividend stocks—typically rise. With interest rates at record lows, most preferreds trade well above their face values. These face values are most often $25 a share. As a result, investors suffer losses when the issuing company redeems the shares at their face values, or just a little above them.

Your yield-to-call matters most

Record-low interest rates also lead companies to redeem older preferred shares. After all, the company can save itself some money by redeeming these preferreds and issuing new ones that pay less than old ones. Unfortunately, investors receive cash to reinvest at a time when low interest rates make such reinvestment unattractive.

Many years ago, we saved a friend money by checking the yield-to-call on one of her Bell Canada preferred shares. On Oct. 25, 1996, our friend asked our opinion about buying Bell Canada’s Class A, Series 8, preferreds. At that time, these preferreds traded at $27.95 each. She noted that the dividend of $1.94 a share would give her a return of 6.94 per cent. We advised her to stay away because the yield-to-call was negative.

Three days later, on Oct. 28, 1996, Bell Canada called in these preferred shares for redemption on Dec. 1, 1996. While the redemption price of $26 a share was above the shares’ face value of $25 (for redeeming at the first opportunity), our friend would’ve suffered a capital loss of almost seven per cent had she bought them.

If your broker recommends you buy an older, existing, preferred share, ask him or her for its yield-to-call. Even if your broker doesn’t know how to calculate the yield-to-call, the experts that big brokerage firms hire probably can. On the other hand, if your broker doesn’t even know what the yield-to-call is, you might consider seeking out a more knowledgeable broker.

Side-step problems with new issues

One way to side-step the problem of low yield-to-calls is to buy new preferred shares. This gives you several advantages. First, the earliest redemption date is years away. The issuing company can’t just snatch away your preferreds. Second, when you buy new preferred shares, you pay no fees. Instead, the brokerage firms make their money from the issuing companies. Third, you’ll buy new preferred shares at (or very close to) their face values. This means there’s no capital loss when they’re eventually redeemed.

Preferred shares offer some advantages over bonds. One is that they pay dividends that are taxed much more lightly than interest payments from bonds. A second advantage is that preferred shares pay dividends four times a year, not twice a year as with most bonds. A third advantage is that preferred shares trade on the stock exchange. This makes their price more transparent. With bonds, by contrast, you often don’t know what price you’re paying.

Seek what we call ‘escape clauses’

Just remember that any preferred shares you buy should contain what we call ‘escape clauses’. These let you get out of what turns out to be a poor situation. One escape clause, for instance, is retraction privileges. They let you sell the preferreds back to the issuing company at a set date and price. You get your money back. Another escape clause is where you can convert into the issuer’s common shares at a fixed conversion ratio. This can become profitable if the common shares rise.

 

The Investment Reporter, MPL Communications Inc.
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