Calculating the yield on preferred shares

There is no shortage of ways to calculate the yield on a preferred share. When do you go by which one?

Preferred_SharesWhen it comes to calculating the yield on a bond or preferred share, there are all kinds of choices. There’s the ever-popular current yield, which is simply based on current income and today’s price.

Then there’s the yield to maturity, which takes into account both current income and any price change between now and the par value you will get at maturity, divided by the average of the purchase price and par.

The yield to first call is calculated the same as the yield to maturity, except that it assumes that the bond or preferred share will be redeemed prior to maturity, and therefore uses the first redemption date instead of the maturity date in the calculation.

There’s also something called the total realized yield, which factors the investor’s marginal tax rate into the income and gains to predict a net after-tax return.

There’s even one called the HTG yield (believe it or not, HTG stands for ‘honest to God’), which takes into account both taxes and inflation, to give you a most comprehensive measure of your prospective return.

In the Oct. 20, 2017 Money Reporter, when you look at our selection of straight preferred shares on our Fact and Advice Sheet, you’ll see two yields. One is the current yield, which for the Fortis Series J preferred shares right now is 5.22 per cent. Then there’s the yield to call, which on the Fortis J shares is 105.9 per cent.

That’s quite a difference, and it may make you wonder which is the one you should base your investment decisions on. That’s what we expand on here.

What you really want to know is whether the preferred is likely to be called in by the company when the first call date arrives, because if so, the yield to call is what you’ll realize, and the current yield will just be a chimera.

It’s unlikely that Fortis will redeem its J shares on Dec. 1, 2017. That’s because it would have to pay you $26 a share on an issue whose par value is $25. What’s more, given the shares’ current price of $22.73, it would be more cost-effective to buy them on the market if they continue to trade at that level on December 1 than redeeming them at $26.

Another way to get a fairly good idea of how likely redemption is for shares that trade closer to their call price is to compare the current yield to the company’s current cost of capital. The cost to a company of having their shares outstanding is calculated by dividing the current dividend by the shares’ par value. If that is not significantly above the shares’ current yield, then the cost of redeeming and replacing them with a new issue of preferreds is prohibitive.

This is an edited version of an article that was originally published for subscribers in the October 20, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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