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NITTY-GRITTY of PREFERRED SHARES - how they work



#1 The Basics

#2 Illiquid and Inefficient

#3 Yield Metrics

#4 Security of Distributions

#5 Price Sensitive to Interest Rates and Company Strength

#6 Maturity, Calls and Retractions

#7 Floating Rate Preferreds

#8 Rate Reset Preferreds

#9 Payment with Common Shares

#10 Ranking Within Capital Structure

#11 Preferred Owners vis-a-vis Common Shareholders

#12 Preferred Owners vis-a-vis Debt Owners

#13 Tax Rates on Dividend Income

#14 Quick Calculation of Yields

#15 Preferred Shares of Split-Share Corp's



The Basics

Basic Understanding Resources
Shakespeare* Yield Calculators - YTC when over $25, and Rate Reset current yield
Blackmont Capital * ETF tickers: XPF, CPD, ZPR, PPS, HFP and HPR

* ScotiaMcLeod 2016 Guide to Preferred Shares - 2015 year end and what happened in year.

* ScotiaMcLeod Canadian Preferred Share Rate Sheet - complete list of current issues with yields and maturity dates, etc. Up-to-date postings come and go on this site.

* Quantum OnLine - listing of all US Pref issues outstanding

* Canadian corporate bond yields- Inclusive list . GlobeInvestor list. Selected issues list. Corporate bond index yields.

* TSX Preferred Share Index metrics and constituents. Index from GlobeInvest


Illiquid and Inefficient

The number of preferred shares outstanding is small. Many have been purchased by retail investors directly on the IPO for very long term holds. Another large block is now held by ETFs. Therefore trading volumes are very small - too small for institutional money to be interested. Investors must appreciate they may not be able to exit their positions in a dignified manner because few buyers exist when bad news happens.

  • One strategy when bad things are happening to a specific company, is to short the common shares of the same company as you take your time exiting the preferred position.
  • You may limit your choices to issues in the benchmark indexes or issues held by ETF portfolios. These are bound to be more liquid, but may not be the optimal securities for your portfolio for other reasons.
  • Or, you can buy Preferred Share ETFs. These trade larger volumes with a tighter spread.

The lack of participation by 'the smart money' means that Preferreds can be mis-priced. This is a risk for the un-schooled investor, but an opportunity for anyone prepared to do their homework. Before deciding there is mis-pricing, consider that it may be you, and not the market, that has things wrong. Since the 2015 growth of Preferred ETFs, relative pricing has become very accurate -- given market sentiment in general. But the pricing of Preferreds relative to debt and equities can still be quite wrong.

It can safely be presumed that most investors make their purchase decision based on the % current yield and the solidity of the issuing company. That level of knowledge is not sufficient. You must have an opinion on the macro economy, track corporate yield spreads, and above all - must read the issuing prospectus. Read it for what it says and what is missing. It may be posted on the company's website, but finding its link can be frustrating. It is better to use SEDAR and EDGAR. First you must know the issue date/year. Try looking at long-term charts of the security to see when it first appears.

Warning! Identifying which preferred issue is trading under which stock ticker can be difficult. Only rarely does the prospectus tell you. Some security called 'X' in the prospectus does not necessarily trade with the ticker 'X'. You can confirm the ticker by looking up sources that post both tickers and descriptions like TMXmoney



Yield Metrics

There are three yield metrics published for preferred share funds and individual stocks. If you buy ETFs pay no attention to the fund's disclosed % yield. All the metrics published are useless and misleading.

  1. A traditional Yield-to-Call. Essentially no Canadian Preferreds have a maturity at which you can expect to recover Par value. There is no way you can force the company to call the shares. YTC is only correct when shares trade above $25 - indicating that the company can/will refinance at a lower cost.
  2. A current yield is calculated by adding up the past year's distributions and dividing by the security's price. Since the securities held by funds will change, and Rate Reset issues will change their coupons, past distributions are meaningless.
  3. Another current yield is calculated by replacing that numerator with the most recent $ distribution annualized. This metric is slighly more relevant, but only for Perpetual Preferreds trading below $25. Even so, this metric can be misleading. For example in early 2016 there were many older issues trading at 20% price discounts because the market was demanding higher rates. New issues came to market at $25, with much larger $distributions, and similar yields. The older issues were much more valuable because they offered the possibility of a 20% capital gain on top of the quoted yield. Yields don't tell the whole story.

Most Canadian issues are now of the Rate Reset type. Since their distributions change every five years, the past is irrelevant. What matters is the expected future distribution. Their adjusted Effective Current Yield % calculation is shown in the Rate Reset section below. All funds will contain securities needing different yield calculations. No one metric will be appropriate for all.



Security of Distributions

Preferred shares are quite different from debt. Once a business defaults on debt interest payments it starts on the slippery slope of insolvency. Not so with preferred dividends. If they are not paid, most likely nothing happens. Payments are at the discretion of management subject only to the covenants of the prospectus.

The most important protection is the requirement that all distributions to common shareholders stop before dividends to preferred owners can be cut. But if there were no common dividends anyway, this is valueless. Preferred owners want a large number of irate common shareholders and the attention of media to keep management under scrutiny and increase the business's cost of capital. For that reason it is a good rule of thumb to never buy preferred shares of any company that is not public and does not pay healthy dividends to common shareholders.

But remember the two downsides to common share dividends. They can deplete the business' assets, which you are considering as collateral for your loan. And they are an additional cost if you need to short-sell the common shares to hedge your downside risk.

The next line of defense is a requirement that preferred dividends be 'cumulative'. That means any unpaid dividends remain due and payable before distributions are allowed to common shareholders. Remember that no interest is paid or accrued on the unpaid balances, and if no distributions were to be made to the common owners anyway this has no effect. The distinction between 'cumulative' and 'non-cumulative' (unpaid dividends are simply forgotten) is further muddied by the prospectus wording "cumulative.... if declared". Only when management declares the dividend does it becomes 'cumulative'. They can escape the obligation by simply not declaring the dividends they have no intention of paying. This is often not clarified until well down the prospectus.



Price Sensitive to Interest Rates and Company Strength

One commonly heard complaint is that "preferred shares suffer when the company suffers, but they do not participate in the business's upside". This is valid ONLY when the stock is purchased at par value (or above), i.e. the value at which most brokers sell it to their clients on the IPO. And even when true, the price of preferreds falls LESS than the common stock (but more than the debt). So they have their place at the right time and at the right price.

chart of 2 year price changeof pref and common shares during credit crisis.

Preferred prices fall for three reasons: (i) a specific company's misfortunes will raise investors perception of risk and they will demand a higher return, (ii) a rise in Treasury interest rates, because the higher distributions from new issues are more attractive than the smaller distributions of seasoned issues. (iii) and an increase in the general risk premium of corporate debt over government debt. This data is far from certain with widely varying ( US) and (Canadian) quotes. Before you buy preferred shares at par consider these possibilities carefully.

chart of US corporate bond yield spreads over Treasuries

Good purchase opportunities appear AFTER a price correction, when trading well below par, and bad news is built into the company's stocks. As sentiment changes, the risk premium falls, or interest rates in the economy fall, the preferred stock will move back up toward par value. You get the healthy dividends as well as the price appreciation with less risk than owners of the common stock face.

At that same time, the company may be floating new issues with a coupon rate equal to the existing issue's current yield. The new issue lacks all possibility for capital gain, so the seasoned issue is usually the better bet.



Maturity, Calls and Retractions

When long-term interest rates in the economy are falling and the business is doing well, you commonly see preferred shares trading at prices greater than par value $25. This is extremely dangerous for owners. The sad results are never noticed by the media because the security simply disappears from the database when the shares are called at par value. While focusing on the extra income, owners end up with a much larger capital loss.

The problem is exacerbated with 'participating preferred shares' (rarely seen) which pay extra dividends if the company achieves some predetermined financial goals. There may be a provision to raise the price at which the shares can be called but often isn't. On the other hand 'convertible preferreds' (rarely seen) allow the owner to exchange their preferred shares for common shares at a preset price. Once the common shares exceeds that price, the preferreds will trade in tandem with them. Their par value is now immaterial.

Most shares now are issued with provisions allowing the company, at its discretion, to 'call' (buy back) them at a predetermined price. Companies will not usually call preferred issues when they are trading below par value. The lower price, and higher dividend yield, prove they would have to issue replacements at a higher coupon rate than the existing security. There may be corporate restructuring reasons for a call, but don't bet the bank on it.

Companies WILL call shares when they are trading above par. From the company's point of view, when things are going well and the market price (above par) proves that they could refinance at lower rates, why would the company NOT call in the preferreds at par and re-issue at the lower rate (except for the 5% cost for the transaction). When considering a purchase above par value, the investor must not be seduced by the current dividend rate. He must subtract from it the annualized capital loss that will result from the company calling the issue at its earliest possibility.

chart of loss from buying above redemption price

There may be a provision that owners can 'retract' their shares (force the company to buy back at pre-determined price). But this provision is rare now. Alternately, the shares may have a stated maturity at which date the company has to redeem them (buy them back at par value). Again this is rare but still exists for some split-share corporations. Until the 2008 Credit Crunch, most preferreds were 'perpetual' with no maturity. Issues were still regularly called because interest rates continually fell lower - allowing companies to refinace at lower rates. Since 2008 most preferred are the Rate Reset type. These won't be called unless the risk premium at which they were issued is priced lower by the market. The lack of a set maturity date and value is a huge downside for preferreds when compared to debt.



Floating Rate Preferreds

Some preferred shares have their coupon set to frequently change with the banks' Prime Rate, or the 90-day Tbill rate. But these should not be thought of as money-market type safe investments. Their valuation is not determined by an arbitrage of the Bank Prime rate (or Tbill rate), because they have the credit risk and long maturity of all Perpetual perferreds. Their yield is set relative to the rate-reset preferreds'. Many issues were IPO'd just before the Credit Crunch in 2008, when the yield curve was flat, and Prime was higher than even the 5-year Tbill rate, at over 5%. Others were IPO'd at prices below par so that their current yield was in line with other preferred shares.

In good times investors bid up their price (bid down the yield) because their rising coupons give protection from capital losses in a rising rate environment. In times of crises, when the Bank of Canada cuts its rate in half, these secuities get hit two ways. Their distributions get cut along with the Prime Rate, and the increasing credit risk of all corporate debt causes large capital losses. So they are more risky than longer term Perpetual Preferreds.

Some floating rate issues are paired with another rate-reset issue, between which owners may swap. This adds complexity to both. The company may force conversion when there are too few shares outstanding of one series. Alternately your right to convert into a series with too few shares outstanding may be blocked. At the date of conversion the shares should have the same price because you could buy either, in order to switch and get the other. But in between times they get valued so that their yields are equal. Too complicated for most people.

chart of yields for 5-yr Treasuries and Bank Prime rates

Some people think that since Floating Preferreds go up in price when Prime rates rise, they violate the basic rule that 'when rates rise, bond prices fall'. The term 'negative duration' is used. But they don't violate the essence of that rule. You just have to rethink what is meant by it. Bonds rise in value when their benchmark's interest rate falls because the securities' distributions are now larger than what the market is paying. What matters is the spread between the securities' distributions and the current market rate. This spread can change when either the security's distribution changes, or when the market rate changes ... the two ends of the spread. Importantly, the 'market rate' benchmark for Floating Preferreds is the 5-yr Treasury rate, not the Bank Prime.

When the Bank Prime rises, the securities' distributions increase, which creates the same effect on the spread as a fall in the benchmark market rate ... so the Floating Preferred's price rises. If the Bank Prime and the 5-yr Treasury rates both rise by the same amount, their spread will not change ... so the Floating Preferred's price would not change.

Warning ---- Notice in the chart above how the Prime rates bottomed and held steady at 3% after the Credit Crunch, even while market-determined Tbill yields fell further. The central banks' rates were still lower. This is because the commercial banks need some spread between the rates at which they borrow and lend. At the zero% boundary they cannot lower Prime further. When the media talks about 'rising rates' (meaning the central banks' rates), you should not presume that the $dividend of a floating preferred will rise. The central banks' rate must first rise enough to recapture the room created by the commercial banks' false floor.



Rate Reset Preferreds

Some preferred shares reset their coupon rate at five year intervals. The reset rate is usually defined as a specified percentage spread above the then current 5-year government Treasury yield. This makes them almost exactly like owning a normal corporate bond, that matures in 5 years, with the proceeds being used to buy, at the same price, the company's newly issued bond, with a then-current interest rate. The company may call the shares at each reset date.

The only difference from normal bonds concerns changing risk. If there is no change in the market's perception of risk then the Rate Reset should stay valued exactly the same as the bond. But risk changes. New issues of normal bonds will have yields reflecting both the current Treasury rate and the market's current assessment of the risk spread. But the preferred's reset rate reflects only the current Treasury rate, because the risk spread is stipulated for all time in the prospectus. Increases in the market's perception of risk will drop the share's price below par permanently to create the necessary added yield.

The market value of these securities is impacted by four variables:

  1. Market Treasury yields change over time. When rates rise, prices fall. When rates fall, prices rise.
  2. The solvency of the issuer and the probability of default will determine what spread above the treasury rate is appropriate. This will change over time, making the stipulated spread 'wrong'.
  3. The shape of the yield curve will determine whether the 5-year Treasury benchmark generates the 'correct' yield for a long-term investment.
  4. Market sentiment can be right or wrong in a market of only retail investors.

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1. Market Treasury yields change. As for all bonds, falling interest rates increase the preferred's price (and vice versa). Lower market rates mean that outstanding securities, distributing larger payments than new issues, are worth more. The increase in price equals the discounted present value of the excess payments until reset. The change in price will be less for Rate Resets than for Perpetuals because the Rate Reset's distribution corrects within 5 years, while the Perpetual's distribution never changes. The call feature of both types of preferreds limits the upside change in price.

Contrary to the claims of experts, resetting at a lower $ coupon, because interest rates have fallen, is NOT a reason for the preferred's price to fall. Values of debt securities are always relative to other securities in the market. Assuming (big assumption) there is no change in risk, the Rate Reset price should correct to $25 par value at each reset. When interest rates fall everyone has to accept the lower yields. Rate Reset preferreds should not drop in price, to create an artificially high yield, without arbitragers correcting the situation.

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2. The spread specified in the prospectus may not continue to be appropriate. Business risk will change the market-wide corporate spread over Treasuries, as the economy moves from recession to over-heated, and back again. Generally, spreads widen when the stock market tanks, and vice versa. The same issuer may have multiple Rate Resets issued at different times with different spreads. The issuer's specific company risk also impacts the spread it pays. Ratings P1 and P2 are considered investment grade. P3 and lower should really cause you to pause. For the risk you assume it might be better to own their common shares.

Credit Rating Spread
Mch 2011
Spread
Jan 2016
Company
Pfd-3(low) 2.9% 9.0% GMP Capital
Pfd-2(low) 1.8% 4.6% Brookfield Asset Management
Pfd-2(high) 1.4% 2.3% Canadian Utilities

When the prospectus-stipulated spread is considered too big by the market, the stock should trade above $25. It will likely be called at the next reset date because the business can refinance at the lower cost. If the spread is considered too small, the stock should trade below the $25 face value, at a higher yield. The security will not be called at the next reset date. This means you should consider the issue to be a 'perpetual'. For any increase in perceived risk, the price drop of a Rate Reset will be larger than that of a Perpetual because the change is a larger part of the Rate Reset's smaller yield.

The take-away point here is that you should not calculate a % yield-to-reset assuming the stocks will then be priced at $25. Most all pundits used this wrong assumption until 2015. It is only those issues with onerous spreads well above the market's current pricing of risk, that are likely to be called or priced at $25 (e.g. those issued in late 2008 when even great businesses could not access credit).

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3. The yield curve of bond markets will affect the market prices for rate-reset Preferreds. In recessions the Central Bank cuts rates at the short end of the curve, making it steeper. The yields splay apart in the chart below. In booming economies, the Central Bank tries to slow the economy by raising rates, creating a flat yield curve. The yields converge together in the chart below.

chart of Canadian treasury yields

The interest rate of the 5-yr Treasury is the appropriate benchmark for Rate Resets as long as buyers believe they will have the choice to exit at $25 at the next reset date. But what happens if the business risk increases causing the stock to trade below $25? This will most likely happen in recessions when short rates have been cut and the yield curve is steep. Rate Resets now have no maturity date and owners want a higher yield to compensate. They benchmark partially against higher Long Bond yields. The yields of Long Bonds compensate for the higher interest rate risk and repayment risk of their long duration. The Rate Reset feature takes care of the higher interest rate risk, but investors will still want compensation for higher repayment risk.

So there is a double whammy when company risk increases. First it causes the stipulated spread to be considered too small, making the stock trade lower, taking away any maturity date. This in term switches the benchmark Treasury yield from 5-yr Tbills to Long Bonds. So the stock trades still lower to create the larger long-term yields.

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4. Market sentiment drives this market of mainly retail investors. There is little correcting influence from knowledgeable professionals. Even the experts propagate false information on which the public relies. E.g. for more than 5 years after Rate Resets were introduced, the public was repeatedly told to value the shares presuming a $25 stock price at the reset date - in other words to presume the risk spread at issue would always remain correct. Even as prices plummet in 2015 their revised calculator still made this same error.

E.g. in 2015 the public was told that Rate Reset preferreds fell in price 'because Treasury rates dropped and distributions were cut.' (ScotiaMcLeod, RaymondJames, CIBC, fund manager, as well as many BNN TV and media reports). Experts argued that investors bought the shares believing that Treasury rates would rise, and were disappointed when they dropped.

This is patently false. When the securities you own reset because of a lower rate, you suck it up, in the same way owners of normal debt suck it up when their securities mature and they buy a new issue at par with its lower rate. Any wrong choice in the past (with perfect hind sight) has no bearing on the value of what you own today. You don't drive down the price of your Rate Resets so that you have both lower distributions AND a capital loss. That is cutting off your nose to spite your face.

The original investors did predict rising interest rates. Since they were told that Perpetual preferreds would drop in value, especially because of their long duration, the Rate Reset was invented to maintain its price as its distributions reset to market rates. That was all true and would equally apply if interest rates fell (which they did). Rate Reset prices should stay steady as Treasury rates change. The only excuse for 2015's falling stock prices is a change in perceived risk.

E.g. in 2016 when the public asked " What will make the stock prices go back up?", the experts said "Only when Treasury rates rise". Why? Supposedly the whole world is reaching for yield. There are Rate Reset issues (e.g. BAM.PR.X) priced to yield the same 4.6% as when they IPO'd five years ago .... even though 5yr Treasury rates have fallen a full 2% (from 2.6% at issue to 0.6%). There is yield for the asking. Stock prices will rise when the public starts ignoring the experts.

E.g. for many years experts pushed new issues onto the public that were wrongly priced. They focused on the coupon and ignored the risk spread. Brookfield Asset Management sold two issues only three months apart - series T on October 29,2010 and series X on Feb 8, 2011. Both paid about the same $$ coupon (4.5% and 4.6%). But because the 5yr Tbill rate rose from 2.06% to 2.61% in the interim, BAM reduced the stipulated risk spread from 2.31% to 1.80%. The experts and public looked only at the similar $$ distribution and thought the series to be equal. They both continued to trade at $25 for a few years, until people cottoned on at last. Series X's smaller spread (2.3% - 1.8% = 0.5%) made it 11% less valuable (0.5% / 4.5%) than series T. The difference in value did not 'show' in the beginning because of the fast changing Treasury rate, but for all future projections no one will presume any change in the Treasury rate at all. Any presumed change in a 3 months period would be a guess at best.

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How much to pay? - compare their effective yields. For those priced above $25 that you presume will be called at the next reset date, use the traditional calculation of 'yield-to-call'. The value of the others depends on assumptions you make about the unknown future. You can use this worksheet to calculate the Effective Yield of a Rate Reset Preferred Share

worksheet to calculate effective yield of rate reset preferred shares

The current Treasury yield determines prices. Add the stipulated % spread to determine the $ dividend to be expected. The $ dividends in the interim will be larger (or smaller). Discount that difference back to the present and subtract it from the stock's current price. The preferred's Effectual Yield equals the future $ dividend as a percent of the adjusted share price.

From that Effective %Yield, subtract the Tbill rate to find the market-calculated spread. The pricing of the shares is validated by comparing this market-calculated spread
* to the prospectus-stipulated % spread of this security and more recent issues from the same issuer.
* to the spread between the yields of the same issuers' perpetual preferred shares, and Long-term Treasury rates.
Any difference should be justifiable by a change in the business risk, or by a change in the slope of the Treasury yield curve, or expectations of changes to future Treasury yields.

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Buy issues priced at Par, or those discounted? - It depends on the direction of interest rates. After Rate Reset prices dropped in 2015, to reflect a risk premium of 3% to 3.25% (from the historical average 2%), companies brought new issues to market with larger stipulated spreads. Now investors must choose between issues from the same company, one priced at par with a high coupon and a large stipulated spread vs. another with a smaller coupon and stipulated spread but priced so far below par that its yield % equals the new issue. The media gives air time to the 'experts' who tell you to buy the new issues. Should you?

Compare what happens when interest rates rise (eg) 1%, from 1% now to 2% at reset in 5 years, holding the market's risk spread equal at (eg) 3%. First consider the new issue (A) priced at $25 par. Now, it's stipulated spread is 3% so both its coupon and yield equal 1% + 3% = 4%. It pays $25 * 4% = $1.00. In 5 years after market rates rise the coupon resets to 2% + 3% = 5%, paying $1.25. It will still be priced at $25.00 par because the market still demands the same 3% risk spread. The owner of this stock has had no capital gain, although distributions have grown 25%. This no different from the owner of a Treasury bond.

Now consider a seasoned issue (B) with a 2% stipulated spread, now paying a 1% + 2% = 3% coupon = $0.75. Since the market demands a 4% yield this issue starts out priced at $18.75 ($0.75 / $18.75). In 5 years with Treasuries at 2% the coupon resets to 2% + 2% = 4% paying $1.00. That is a 33.3% increase. It is larger than (A)'s 25% increase because the 1% change in rates is larger relative to the smaller coupon. The market will price this issue at $20.00 ($1 / $20 = 5%), for a 6.7% capital gain.

Issue Stipulated
Spread
Coupon PaymentsStock
Price
Now 5 yr Treasuries pay 1% and market risk premiums = 3%
(A) 3% 4% $1.00$25.00
(B) 2% 3% $0.75 $18.75
Reset in 5 years when Treasuries pay 2%
(A) 3% 5% $1.25
25% growth
$25.00
0% gain
(B) 2% 4% $1.00
33% growth
$20.00
7% gain

If market interest rates fall, instead of rise, the discounted issue (B) will have a larger drop in payments and suffer a capital loss. You must predict future interest rates in order to make this choice between issues. Also consider that the analysis above presumes the market's price of risk does not change. Any decrease in risk spreads creates larger capital gains for the discounted issue, but vice versa. Sweeteners offered to make new issues more attractive, eg. putting a floor on coupons, will be of little value if rates rise, but vice versa.



Payment with Common Shares

Some preferred issues allow distributions to be paid with common shares instead of cash. This is a pain-in-the-neck for investors. Most often the calculation of 'market value' used is so convoluted it is impossible for owners to hedge their exposure between the time the dividend is valued and the common shares received.

The redemption of preferreds using common stock instead of cash is more frequent than the use of common shares for distributions. These differ from Participating Preferreds because the value of the common shares used in the calculation (of how many are issued) is not pre-determined. Their market value is used, so theoretically the preferreds don't lose anything. But these also presents dangers. You should expect that most preferred share owners will try to sell the common shares they receive as fast as possible. So losses will accrue after receipt of the common shares.

When the number of outstanding preferred shares is large, or when the company has experienced losses that destroyed common equity, the issue of additional common shares can be very dilutive. The market will realize this and bid down the common stock's price further in anticipation. And / or the common's price may be bid down by active short-selling of the common stock by the preferred owners. The lower common share price means that more shares must be issued to satisfy the preferred's redemption, leading to further price pressure, and further dilution, etc. A death spiral.

The death spiral is prevented with a clause that specifies a minimum value for the common stock used in the number-of-shares calculation. This limits the number of shares that must be issued to retire the preferreds and prevents excessive dilution. It also means that the preferred owner does not recover full par value.

Become very wary when the common stock's price goes anywhere near the cut-off point and the issue may be called. Management then has a vested interest in breaking bad news to drive the stock further down. Bad news is easy to manufacture. Once the stock has tanked they call the preferreds, short-paying with common stock.

The preferred's owner can hedge by shorting the common stock before it breaks below the minimum value. Remember to factor in the costs of making good for any distributions. There is also a problem if the common shares rebound. There is no off-setting gain on the preferred position when the common are above the minimum value.

The preferred's owner can also buy a Put Option on the common stock at the minimum price, as long as their options are traded. Market arbitrage will make sure that the preferred is valued as if its dividend has been reduced by the yearly cost of the option.



Ranking Within Capital Structure

A great deal of emphasis is commonly placed on the fact that preferred shares are higher up the capital structure and have less risk than common shares. But does it matter? Will it make any difference if one issue of preferreds (prior preferreds) or one series of issues (preference preferreds) ranks before another? Will it even matter that preferreds rank higher than common shareholders?

The priority of claims only matters when things go very wrong. At that point the valuation of assets changes completely. The 'going concern' presumption is dropped. Goodwill, making up so much of today's balance sheets, has no value. Intangibles were simply capitalized costs with no re-sale value. Equipment with value in use, has no value at auction. Face it. In the event of collapse the common and also the preferred owners will be wiped out.

Investors should not expect that a higher yield compensates for the risk of loss of principal. It is much smarter to pick the safe company and buy the riskiest security of that company. Your working presumption should be that you get nothing at all in insolvency, so avoid all companies with that possibility.

The company assets working as collateral for the preferred shares can be easily transferred to others. E.g. In this age when investors put a high value on distributions, companies have created subsidiaries with new equity owners, into which they drop down mature assets with high cash flows. The parent company's preferred shares are then left with only an equity interest as collateral. Or the company may issue new debt that is 'asset-backed'. In other words the new lender has first dibs on those tangible assets, taking them away from the preferred owners.



Preferred Owners vis-a-vis Common Shareholders

Within the going concern presumption, the preferred's security of principal depends on a healthy balance of common share equity below them. There must be covenants preventing those common shareholders from stripping the company of assets and leaving the preferreds with only a shell at worst, or at best with all the risk and none of the possibility for gain. There may be wording like " No cash dividends may be paid to common shareholders, or securities retired, unless tangible assets remain greater than 140% of the senior securities in total."

Or a covenant may say that "Common share dividends may be paid only from the earned surplus". The company can get around this restriction by reclassifying equity from "Stated Capital" to "Earned Surplus". For example, if all the shares were originally issued at 'no par value' all the proceeds would be sitting in Stated Capital. By reissuing the common equity with shares of a low par value, the surplus would become free for distribution to common shareholders. This kind of thing happens after a period of sever losses have depleted the Earned Surplus account.

Friendly takeovers are often accomplished using mechanism called A Plan Of Arrangement. These are judged 'fair' by the investment banker the company hires to say so. The price offered will probably not be $25 par value. More likely it would be the market value of a similar issue of investment grade. Not tendering is not really an option because they have mechanisms to squeeze out the die hards. Nor should you expect an approval vote for preferred owners separate from the common shareholders.



Preferred Owners vis-a-vis Debt Owners

The existence of debt above the preferreds makes them much more risky. Debt owners have the same concerns regarding the maintenance of assets and the security of payment, that the preferred owners have. Debt owners will use the same kind of covenants for their own benefit. These covenants will restrict payments to preferred owners just like the preferred's covenants restricted payments to common shareholders. Knowing what is in those debt covenants is impossible for the retail investor. They are not made public, so you can only surmise the worst.

The preferred owners will react the same way the common shareholders did above. In the situation where earned surplus has been eroded, the debt owners will want to stop dividends to the preferreds. The preferreds will WANT to recapitalize equity now, because it will serve both themselves and the common shareholder. But now the common shareholders, who control the necessary vote, can hold the preferred owners hostage. They can demand the preferred owners give up their right to cumulative dividends, or waive back dividends, etc.

It should be obvious that another necessary covenant of the preferred issue should be to limit, or require approval of, the issue of any debt or preferred senior issue. But dream on. Even that would not prevent the dilution that occurs when additional securities within the same class of preferred shares is issued - which is most common.



Tax Rates on Dividend Income

The following is from the POV of a Canadian company. Tax rules vary by country.

Generally, a company cannot deduct the dividends it pays on preferred shares from the income on which it pays income tax. Dividends are paid from after-tax income This is a great disadvantage compared to the interest on debt, which is tax deductible.

The opposite is true from the investors' point of view. Dividends are taxed at a low and even negative marginal rates because the operating earnings from which they come have already been taxed within the company. Since all investments should be evaluated on an after-tax basis, dividend yields are not directly comparable to GIC interest rates or bond yields. The tab at the bottom of this Marginal Tax Rate spreadsheet called "Equivalent Returns" shows how to find the rates that are equivalent after-tax.

Not all preferreds pay dividends that are treated as such for tax purposes. Some preferreds pay interest income even while it is called a 'dividend'. Other securities are labeled as debt and pay interest income, yet transform into a preferred when the company is in trouble. Investors must read the prospectus carefully. Also, dividends received by Canadians from foreign companies, are taxed at the full personal tax rate, not the reduced dividend rate.

It is always wise to evaluate the price of an investment from the other side's point of view. Comparing the preferred's coupon rate with the rate of the company's other debt will help you evaluate how motivated the company will be to redeem the shares. Make the analysis 'after-tax'. Calculate the equivalent interest rate by dividing the coupon rate by (1 - taxrate). For example, if the company accrues tax on its Income Statement at 35 percent and the preferred's coupon rate is 6 percent, then equivalent interest rate would be
6 % / (1 - 35%) = 9.2 percent



Quick Calculation of Yield-To-Call

When shares trade above Par value their yield should be measured using the YTC, not the current yield. The promise of a capital loss needs to be inclued. Be sure to use the correct $$ call value. Some issues have a sliding call value - starting at $26 at some date, but declining by $0.25 each year until $25 is reached.

Preferred shares commonly pay dividends quarterly, not semi-annually like bonds. Therefore the bond functions on your calculator will not work for preferred shares. The best calculator on the web is Shakespeare's spreadsheet. But you often need a rough and ready calculation with just your handheld financial calculator.

Consider the yield as the sum of two factors. (i) The current yield is probably already posted on the website you are using. ( Dividend$ divided by Share Price). (ii) The other factor is the expected capital gain or loss from changing stock prices. You can use the par value at maturity, or the redemption value at call, or your expected price at any specified future time.

Here is an example.

  • Stock now (Feb4-09) at $26.50
  • Callable Dec31-11 at $25.50
  • Coupon = 5% = $1.25/yr = $0.3125/qt
  • (i) Find current yield = 1.25/26.5 = 4.717%
  • (ii) Find the capital loss using Present Value of a Dollar function:
    • PV = 26.50
    • FV = 25.50
    • n = 2 years + 11 mo = 2.92
    • solve for i% = Negative 1.309%
  • Total return = 4.717% less 1.309% = 3.408%

That compares to the exact calculation from the spreadsheet = 3.6%. Close enough.

Second example.

  • Stock now (Dec31,08) at $17.00
  • Market yield in 5 years is 6% (therefore price = $1.25/6% = $20.83
  • Coupon = 5% = $1.25/yr = $0.3125/qt
  • (i) Find current yield = 1.25/17.00 = 7.4%
  • (ii) Find the anticipated capital gain using Present Value of a Dollar function:
    • PV = 17.00
    • FV = 20.83
    • n = 5 years
    • solve for i% = 4.2%
  • Total return = 7.4% plus 4.2% = 11.6%

The exact calculation from the spreadsheet = 11.3%. Close enough.



Preferred Shares of Split-Share Corp's

In recent years, as the media has gone whole-hog selling dividends as the best type of income, the folks dreaming up structured products have responded by creating more split-share corporations that include a class of preferred shares to meet this demand.

Most all of the comments above apply equally to this class of shares, but there is one important difference that is frequently ignored. You hear the media and pundits comparing the preferred shares of the active business on an equal footing with the preferreds of a split-share corporation which holds the common shares of that same active business. These two securities are NOT equivalent. Their risk differs.

The split-share corporation owns ONLY the common shares of the active business. (There are a small number of exceptions). Both classes of its shares, common and preferred, are exposed to the common-share-equity-risk of the underlying investment. Split-share preferreds can never attain the reduced risk of the preferred shares issued directly from the operating company. Any pain will be first felt by the common shareowners of the split-share corp, so the preferred have a slightly lower risk. But once the NAV of the common shares has been depleted by big distributions that cushion is gone.

A second problem with these securities arose after the stock market crash of 2008. Since many split-share corporations were leveraged 50:50, after the underlying company's stock tanked 50% there remained only enough assets to cover the preferred's eventual redemption. In reality the preferreds now have all the downside risks of equity ownership. Yet their upside is limited to their redemption value.

The offsetting opportunity in this situation can be found in the common shares of the split-share corp. Since they no longer have any assets underlying them, they trade at their 'option' value. Because the market is limited to retail investors who know little, that option value may well be priced WAY TOO LOW.