Why I prefer to avoid preferred shares (Alternative Investments, Part 2)

This is the second video in a multi-part series about alternative investments. In the first video in this series, I told you why high-yield bonds fall short on a risk adjusted basis, and should only be included in your portfolio in small amounts through a well-diversified low-cost ETF, if at all. If you haven’t watched it yet, click here. And BTW, I do not recommend high yield bonds in the portfolios that I oversee.

Alternative investments are generally sold on the basis of exclusivity to wealthy individuals. Warren Buffett said it best in his 2016 letter to shareholders: “Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice.”

In addition to high yield bonds, income-seeking investors may turn to preferred shares.

Preferred shares typically offer higher yields than bonds. They also have some tax benefits for Canadians who own Canadian preferred shares. While these benefits are attractive, preferred shares also come with additional risks and complexity that bonds do not have. Remember, risk and return are always related.

Preferred shares are equity investments in the sense that they stand behind bond holders in the event of bankruptcy. In a bankruptcy, debt holders would be paid first, followed by preferred shareholders, and then finally common stockholders. Typically, preferred and common shareholders will receive nothing in a bankruptcy. Where preferred stocks differ from common stocks is that they do not participate in the growth in value of the company. The return on preferred stocks is mostly based on their fixed dividend.

Unlike a bond, preferred shares do not generally have a maturity date. This makes them effectively like really long-term bonds. Unfortunately, fixed income with long maturities tends to have poor risk-adjusted returns. Long-term fixed income also exposes you to a significant amount of credit risk. Can the issuing company pay you a dividend for the next 50 plus years?

Like a bond, if interest rates fall, the price of perpetual preferred shares can increase. While this sounds good, the problem is that perpetual preferred shares typically have a call feature. If interest rates fall too much, the issuer will redeem the preferred shares at their issue price. The same thing can happen of the credit rating of the issuing company improves, allowing it to issue new preferred share or bonds at a lower interest rate. This creates asymmetric risk for the investor. They get the risks of an extremely long-term bond, but have their upside capped.

One of the most common types of preferred shares in the Canadian market are fixed reset preferred shares. These have a fixed dividend for 5-years, which is then reset based on the 5-year government of Canada bond yield plus a spread. Investors are able to accept the new fixed rate, or convert to the floating rate. This process continues every 5-years. In 2015, rate reset preferred shares dropped in value significantly, causing the S&P/TSX Preferred Shares index to fall 20% between January and September 2015. Hardly a safe asset class.

Preferred shares have some other characteristics that make them risky. A company is usually issuing preferred shares because they want to raise capital but are not able to issue more bonds. This could be because they can’t pile any more debt onto their balance sheet without getting a credit downgrade. Companies also have a much easier time suspending dividend payments on preferred shares, which they can do at their discretion, than they do halting bond payments, which would mean bankruptcy. These characteristics might cause an investor looking for a safe asset to think twice.

Enough negativity. Why does anyone invest in preferred shares? I’ve already mentioned the higher yields that preferred shares offer compared to corporate bonds, making them attractive to an income-oriented investor. Canadian preferred shares also pay dividends that are taxed as eligible dividends in the hands of Canadian investors. This might make preferred shares a good candidate for the taxable account of an investor that pays tax at a high rate. Preferred shares do also have returns that are imperfectly correlated with other asset classes, meaning that there can be a diversification benefit to including them in portfolios.

So, should you invest in preferred shares? For their few benefits, preferred shares have substantial risks. In Larry Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes that “The risks incurred when investing in preferred stocks make them inappropriate investments for individual investors.”

I do not recommend preferred shares in the portfolios that I oversee. In a 2015 white paper my PWL colleagues Dan Bortolotti and Raymond Kerzerho recommend that if you are going to invest in preferred shares, you should only use them in taxable accounts, limit them to between five and fifteen percent of your portfolio, and diversify broadly. They also emphasize that you should avoid purchasing individual preferred shares due to the complexity of each individual issue.