Preferred stocks, once a little known corner of the investment market, have taken a more prominent role as corporations seek to provide investors with the reliable income stream of debt instruments with the potential for greater returns offered by equities.
On the Toronto Stock Exchange, most preferred stocks are issued by large financial institutions. Although preferred shares are traded as equity securities, these instruments are unique in having characteristics of both stocks and bonds.
They are typically popular with individuals who seek a steady source of income from dividends and the tax advantages afforded by dividend tax credits. However, an investor’s positive view of preferreds is put to the test when central banks begin to raise interest rates. When rates go up, the value of preferred shares will usually decline.
This happens two ways: The steady dividend that an investor receives with a preferred stock is worth less as inflation erodes purchasing power across the board. When it becomes less attractive than other investment options, capital flees preferred shares and the price of these stocks declines.
Monetary tightening is happening on both sides of the border. In Canada, the Bank of Canada began raising rates in March, ending a period of interest rate stability that had existed since October of 2018. In the U.S., the Federal Reserve is pursuing an aggressive policy of rate increases, after acknowledging that inflation is not under control. Both central banks have indicated that rate hikes will continue in the near-term.
One way to limit losses in this scenario is to sell your preferred stock early in the trend. Sometimes companies will make that decision for you, as they have the right to “call in” the shares. A corporation’s board of directors also has the right to withhold dividends. If the preferred shares are “cumulative,” a missed dividend must be paid at a future date before any other dividends are paid, however.
Other features of preferred stocks include:
Although preferred shares usually lack the voting rights of common stock, they have preference over common shares in the payment of dividends. Not surprisingly, this benefit is the reason these instruments are called preferred stocks. Being first in line for any dividend payment is appealing to many investors.
Preferred stocks are generally less volatile than common stocks. But this can also mean that a shareholder may realize less benefit from exceptional company successes.
Preferred stocks with “convertibility” can help an investor increase the upside potential. Preferreds with this feature can be converted into common stock, allowing investors to benefit when the growth of the business accelerates.
Types of Preferreds
Adding to the complexity of preferred stocks is the fact that there are several versions to choose from.
Floating rate preferreds feature a variable yield. Much like an adjustable interest rate on a credit card, the dividend is tied to an interest rate benchmark. When interest rates rise, the preferred stock’s yield also “floats” upward.
Other types of preferred shares include perpetuals, retractables and rate resets. Perpetual preferred shares pay an investor a predetermined dividend for as long as it is held in a portfolio. There is no maturity date. This offers stability, but also magnifies the risk that rising inflation and interest rates will eat away at the value of the yield. Retractables, by contrast, come with a set maturity date.
“Rate resets” have built-in reset dates, at which time the dividend rate may change. In Canada, this adjustment will usually be based on the yield of Government of Canada bonds. In this sense, rate resets occasionally “float,” blurring the distinction among preferred stocks to some degree.