I have always dismissed preferred shares.  The definition I heard was that preferreds are a hybrid of both equity and fixed income investments with the worst characteristics of each, and who would want that?  Plus their special added features – redeemable, callable, retractable, convertible, perpetual, cumulative – just seemed too complicated to me.

Related: Why retirees are looking for alternative investments

However, investors have been increasingly turning to preferred shares to complement their fixed income portfolios.  Preferreds generally pay higher yields than common shares and can offer a better after-tax yield than bonds of a similar quality.

This is what I’ve learned.

An overview

Like common shares, preferred shares represent partial ownership in a company, although they do not have any voting rights.

They rank above common shares in receiving dividend payments and have a greater claim on the company’s assets should the company have to liquidate.

Preferred shares have a par value and pay a fixed dividend that is set at the issue date and does not fluctuate.

They have less volatility than common shares and tend to trade around their par value so you will not get long-term capital gains.  However, like bonds, their value can fluctuate inversely to interest rates.

Related: Are bonds a safe investment?

Another downside is that the shares can be “called” by the issuing company on a specified date at a fixed price, usually the original purchase price.

Buying preferred shares

Most investors prefer issues from blue-chip companies such as banks and utilities.  Their trading symbols will have a .PR suffix.

Take some time and care to review some candidates and their features.

Perpetuals pay a fixed dividend for as long as they are outstanding and have no maturity date.

Retractibles pay a fixed dividend, but holders can redeem them at par value on a set date.

Floating rate shares pay a dividend that changes based on some reference rate, usually the prime rate.

Rate reset preferred shares have been growing in popularity.  They pay a fixed dividend until the reset date – usually a 5-year term – reflecting current interest rates.  It’s a good idea to use a ladder of rate-reset shares similar to a bond ladder to limit the effect of possible rising interest rates on your portfolio, or to match maturities to your future cash needs.

You can also select shares that have different quarterly dividend payment dates to provide a smooth income stream.

An ETF alternative

If you are uncomfortable picking individual preferred shares, an ETF can be a good option.  Here are two examples:

iShares S&P/TSX Canadian Preferred Shares (CPD) has a current yield of 4.51%

BMO S&P/TSX Laddered Preferred Share ETF (ZPR) uses equally weighted 5-year rate-resets and has a yield of 4.95%

Related: Should you buy a dividend ETF?

Tax treatment

One advantage of owning preferred shares is that their dividends benefit from the advantageous dividend tax credit making them more suitable than bonds for non-registered accounts.

One caveat though, if your taxable income is hovering in the OAS claw back range the dividend gross up could put you over the limit, reducing your benefits.  Do some calculations first.

Conclusion

There may be a place for preferred shares in an investment portfolio.

The main reason to invest in preferred shares is for investment income.  They offer diversity and may pay higher dividends than common shares.  The favorable tax treatment can offer a better after-tax yield than bonds of similar quality.

Final thoughts

You shouldn’t dismiss an investment just because you don’t know much about it, but neither should you jump in with both feet.  Being informed is what makes you a good investor.

Related: How to build a dividend portfolio

Have you learned something new lately that could impact your investment strategy?


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