Preferred Share Anomaly

From time to time, things happening in financial markets just don't make much sense.

There is a reasonably large seller in the market of a Canadian preferred share ETF, likely because the ETF is now holding a greater amount of the Fixed-Rate Reset Preferred Shares and with the current level of low interest rates, when the rate on these types of preferred shares are reset, they are reset at lower levels paying a lower dividend as a result and making the issue less attractive. 

Preferred share markets are not as actively traded as common share (equity) markets and therefore there is somewhat less liquidity. As a result, a large seller can move the market price lower without much trading volume.

However, when the ETF basket is sold, all of the preferred shares in the basket are sold, including the Perpetual Preferred Shares with fixed dividends. Naturally this pushes the prices of these perpetual preferred shares lower and as a result of the fixed dividend, pushes the dividend yield higher (and this is what does not make sense): higher returns (dividend yield) in a low return environment.

What are the risks of owning Perpetual Preferred Shares ?

• The "Credit Risk" otherwise known as the ability of the issuer of the shares to pay the dividend (usually quarterly) and of course redeem the preferred share at its maturity (which is usually when, after a specific date, the issuer wishes to mature the outstanding preferred shares) at its issue price or better.
• The rating agencies, Dominion Bond Rating Service (DBRS) and Standard and Poors (S&P) usually rate the "investment grade" or good quality issues:  most Canadian Bank Perpetual Preferred Shares are rated "Pfd-2h (high)" (DBRS) or P-2 (S&P). Canadian Insurers have a slightly higher rating (the reasons for this difference are detailed and a little more than the scope of this blog, but I am always happy to discuss it in more detail off-line).
• Importantly, if you can pick up a good quality Perpetual Preferred Share at a discount to its par value (usually $25) and the issuer can only call it at its issue price or better, there is potential for a capital gain.
• If you can get a dividend yield at or better than 5.5% (which you can at the moment), you are going to get a better after-tax return than you would on a bond with the same yield because of the dividend tax credit.
• You have to be prepared to hold these issues until the issuer decides to mature them to realize the capital gain and there is a risk that in this time period interest rates may go higher, so there is "Interest Rate Risk" involved.
• As I mentioned earlier, there is also less liquidity in these issues, so they may be more difficult to sell, but there is usually always a market maker who will make a reasonable price, especially in the good quality issues.

At the moment, some of the good quality issuers' Perpetual Preferred Shares look very reasonably priced, relative to the bond market and this may be a good opportunity to add these income producing assets to a portfolio if you have room to do so in your diversified, balanced portfolio.

Determining whether you have room is a more complex decision and should be done in conjunction with professional assistance.

www.highrockcapital.ca

It is Webinar Day at High Rock, so feel free to tune in to our latest thoughts on the global economy, financial markets and wealth management strategy (recorded version) after 5pm at

http://www.highrockcapital.ca/current-edition-of-the-weekly-webinar.html