Should Preferred Shares Get Top Billing In Your Portfolio?

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1 Investment Strategy Should Preferred Shares Get Top Billing In Your Portfolio? When boosting the income potential of your investments, consider what preferred shares have to offer. With features that combine elements of equities and bonds, this flexible tool is worth a detailed conversation. Khaled Sultan, MBA, CFA Investment Advisor 255 Queens Avenue, Suite 2200 London, ON N6A 5R8 (519) khaled.sultan@cibc.ca Greg Murray Investment Advisor Assistant greg.murray@cibc.ca (519) Preferred shares typically appeal to a variety of investors. Some individuals may choose to invest in preferred shares because they often provide a reliable stream of income that is taxed more favourably than bonds and other interestearning investments. Others may invest in preferred shares during volatile times because they want to take advantage of a stable dividend payout. Before purchase, investors need to understand the basic features of preferred shares and how to take advantage of their preferential tax treatment. Also, investors should be aware that the dividend payout is not guaranteed and could potentially be withheld if the company experiences a cash flow issue or decides to preserve cash. How They Work Considered fixed income investments, most preferred shares resemble bonds because they have par values and fixed annual or quarterly dividends that are a percentage of their par value. As such, they trade in the open market on an annual-yield basis and are affected by general market conditions and the issuing company s fundamentals. Not surprisingly, their market price tends to fluctuate inversely to current interest rates. However, the market prices of some types of preferred shares, such as those with floating-rate dividends, may be positively correlated with interest rate fluctuations. Unlike conventional bonds, most preferred shares do not have maturity dates, and companies are under no obligation to redeem the shares in the future. When assessing preferred shares, investors often consider the current yield, which is the annualized dividend expressed as a percentage of the preferred share s market price. For example: ABC Co. s Preferred, Series B, has a $25 par value and currently trades at $22. Its quarterly dividend is $0.30. This means its current annual yield is 5.5 percent, calculated as ($0.30 x 4) $22. The yield to call is another key consideration and is often of greater importance than the current yield. The yield to call is the preferred share s annualized rate of return, taking into account all the dividends to be received until the call date, as

2 Understanding Your Unique Needs My concept of wealth management keeps your whole life in focus-since managing your money does not end with managing your portfolio. Your business, philanthropic and lifestyle pursuits all play a role in this process. One To One Insights offers you relevant and engaging articles that can bring you closer to achieving your ideal lifestyleand the means to support it. well as the redemption proceeds. Inherent in the calculation of the yield to call is the assumption that the preferred share will be called on the call date. Yield to call is similar to a yield to maturity on a bond, except that the call or redemption of a preferred share is not guaranteed to occur. General Features Unlike bondholders, who are considered creditors, preferred shareholders are part owners of a company. They usually rank behind bondholders and debenture holders, but ahead of common shareholders, in the distribution of assets if a company winds up. Companies can issue various classes of preferred shares and, within each class, several series of preferred shares. A company can have all of its preferred issues ranked equally, or some issues may be subordinate to others. Preferred shareholders are normally entitled to dividends before any dividends are paid out to common shareholders. This allows income from preferred shares to be considered more reliable than income from common shares. Unlike interest payments on bonds, companies do not have to pay dividends on preferred shares. However, some preferred shares have a cumulative feature whereby if a company misses one or more dividend payments, the payments accrue and must eventually be paid before common share dividends can be declared or before the company can redeem the preferred share. Non-cumulative shares, on the other hand, pay investors dividends only if the company declares them. Even if the company subsequently defaults, it is not obligated to ever pay any missed dividends on non-cumulative shares. Voting rights may be granted to preferred shareholders if certain conditions are met e.g., if a company suspends payment of a pre-stated number of dividends (usually six or more). In Canada, banks, insurance companies and utilities represent a large part of the preferred share market. Preferreds are often thinly traded or may not be listed, and there may be little information on them, making some issues difficult to analyze. Special Features Many preferred shares have one or more of the following special features: Callable or redemption features. The vast majority of preferred shares are callable (or redeemable), which means the company has the option of buying back the shares on and/or after a preset date. Investors whose shares are called for redemption are sometimes entitled to receive a small premium over the shares par value (typically, this premium declines each year until the call price equals the preferred share s par value). Most preferred shares cannot be called for at least five years after they are issued. This is referred to as call protection and allows shareholders to enjoy a steady stream of regular income in the early years of ownership. To benefit from lower financing costs when interest rates are declining, some companies may start calling in and replacing older preferred issues with newer ones. Usually, companies call in preferred shares if the current yield of the preferred shares is substantially lower than the rate being paid out by the company. Thus, preferred shares whose market price is above the redemption price are more at risk of being redeemed early than those trading below the redemption price (prices and yields are inversely correlated). If such preferred shares are called for redemption, the investor loses the future dividend stream, as well as the premium at which the shares traded in the market. For this reason, investors pay close attention to the yield to call, which incorporates the capital loss (or capital gain) that would be realized if the preferred share is called for redemption. Reset features. Fixed-reset preferred shares, also known as rate-reset preferred shares, pay a fixed dividend rate for an initial stated period (usually five years), after which the issuer has the option to redeem them. If not redeemed, the dividend rate is then reset for the subsequent fixed-rate period (again, usually five years). When the rate is reset, it is typically based off interest rates at that time. Thus, if interest rates are higher than when the preferred share was issued, the dividend rate could be reset upward; if interest rates are lower, the dividend rate could fall. Most fixed-reset preferred shares also give the holder the option of converting into another series of preferred share (usually floating rate) at the time of the reset. Note, however, that holders will not have this option if the issuer chooses to redeem the fixed-reset preferred share rather than reset the dividend rate.

3 Retraction privileges. If preferred shares are retractable, shareholders have the right to sell them back to the company. Buy-back rules are defined in the terms of the issue, but must be set at a fixed price either on a certain future date or after a certain future date. This provides a floor price at which shareholders can sell their preferred shares if interest rates are higher than when issued. Frequent retraction privileges are more appealing than infrequent ones. Many retractable preferred shares are soft retractable preferred shares. This means that the retraction price may be paid either in cash or common shares of the company, generally at the election of the company. The number of common shares an investor would receive upon retraction is typically dependent on the average market price of the common shares over a specified trading period before the retraction date. Conversion rights. Conversion rights entitle preferred shareholders to convert their shares into common stock or into another series of preferred shares on or after specific dates at predetermined exchange ratios. Conversion privileges serve as sweeteners and are intended to attract investors to a company that may otherwise be unable to raise funds in capital markets, possibly as a result of unfavourable market conditions or regulatory constraints. As previously mentioned, fixed-reset preferred shares typically offer conversion rights. Sinking funds. Some preferred shares may gradually be redeemed through either a sinking fund or a purchase fund. With a sinking fund, a specific dollar amount is used to redeem a portion of outstanding shares in the open market or by calling shares in. With a purchase fund, the issuing company buys a fixed number of outstanding shares once the share price falls below a predetermined amount. Both sinking and purchase funds offer a small amount of price support for a preferred share issue, since the shares generally will not drop below the redemption price. Warrants. Some preferred shares (usually those issued as part of an initial public offering) have common share warrants attached to them. This provides shareholders with the opportunity to buy common stock commission-free. Because shares and warrants are considered separate securities, shareholders can sell part or all of the warrants while retaining their preferred shares. If the warrants are not exercised by a preset date, they expire worthless. Preferred shares issued with warrants often have a lower dividend rate than those issued without warrants. Tax Treatment Dividends. Generally, dividends from preferred shares of Canadian companies are taxed more favourably than interestearning investments, such as bonds and GICs. This results in a better after-tax rate of return. Unlike interest payments on bonds, dividends are paid out of a company s net after-tax earnings and, unlike interest payments, are not a tax-deductible expense for the company. Shareholders receive tax relief on dividends from Canadian corporations through the gross-up and dividend tax credit. Most dividends paid by publicly listed Canadian companies will be eligible for a gross-up (which is intended to bring the dividend up to what the pre-tax income of the corporation was) and a tax credit (which is intended to represent the tax already paid by the corporation). For an Ontario impact of currency risk on preferred shares To diversify holdings, some investors buy preferred shares in a foreign currency, such as U.S. dollars. This is a particularly popular strategy for individuals concerned about volatility in the Canadian dollar, as dividend income can be linked to other currencies. However, this strategy comes with risk: The foreign currency of the investment may decrease in relation to the Canadian dollar. When Canadian-issued foreigncurrency preferred shares are redeemed, the amount of capital gains or losses and deemed dividends could be higher or lower than for shares based in Canadian currency due to the movement of the foreign currency relative to the Canadian dollar. When interest rates are lower in the country in which a foreign-pay preferred share is denominated, the issue yields less than a similar Canadian-pay issue. Foreign company dividends are ineligible for the gross-up and dividend tax credit, so they are taxed like interest income. In addition, dividends paid on shares issued by a U.S. company may be subject to withholding tax when shares are owned by a non-u.s. resident. The shares may also be subject to U.S. estate taxes, even when held by a Canadian resident. investor earning an annual income of $140,000, for example, $1,000 worth of eligible dividend income will be reduced to approximately $705 after tax, compared with about $536 in interest income. (In some provinces, the bottom tax bracket marginal rate on eligible dividends is negative.)

4 However, as a result of their favourable tax treatment, before-tax yields of preferred shares may be lower than those of other fixed income investments issued by comparably rated corporations. Some companies issue stock dividends rather than cash. In this case, the tax treatment is as if a cash dividend was paid and automatically invested in shares. Shares sold on the secondary market. As with common shares, any capital gains must be included in taxable income in the year the shares are sold. A loss generated when the proceeds received are less than their adjusted cost base is treated as a capital loss and can be used to offset current capital gains. Unclaimed capital losses can be carried back three years or forward indefinitely to offset capital gains. Converted shares. There is usually no tax liability upon conversion. Generally, a capital gain or loss will only be realized once the shares received from the conversion are sold. Called shares. Preferred shares that are called or redeemed will generate either a capital gain or loss, depending on the shares purchase price. As well, if the redemption price exceeds the paid-up capital of the shares, the excess will be deemed a dividend. Strategies 1. Hold preferred shares outside registered plans, including Tax-Free Savings Accounts (TFSAs), to take advantage of the preferred tax treatment. There are three disadvantages to holding preferred shares in registered accounts: income at regular marginal tax rates when income is withdrawn from the plan (other than TFSAs). If the shares are sold for less than the adjusted cost base, investors cannot claim the capital loss for tax purposes. If the shares are later sold for more than the adjusted cost base, investors holding shares in registered plans other than a TFSA will pay tax on 100 percent of the capital gain upon withdrawal. They will not be able to take advantage of the lower tax rates available for capital gains. 2. Ensure that preferred shares have a cumulative dividend feature if seeking income over growth. Preferred shares with a cumulative dividend feature offer some protection to their shareholders because any unpaid dividends accrue (although no interest is paid on the accrued debt). 3. Investigate floating preferreds if interest rates are expected to rise. While most preferred shares have fixed dividends, some offer variable-rate dividends linked to a specific benchmark, such as the prime rate or an index. This enables investors to benefit from a higher dividend if the benchmark increases. Conversely, they would receive a smaller dividend if the benchmark declines. 4. Consider buying fixed retractable shares during times of fluctuating interest rates. By doing so, investors can either lock in a good yield if rates fall or sell the security at a preset price in the future if rates rise and the issue is no longer attractive. Remember, since dividends are fixed, investors must consider how inflation might affect their purchasing power. a less volatile investment than most common stocks. Preferreds typically exhibit higher correlation with bonds during periods of relative prosperity, and with stocks during times of economic uncertainty. Before purchase, investors should ensure that the preferred shares suit their overall financial goals, risk tolerance, time horizon and investment objectives. There are ways to determine whether a company is likely to maintain its dividend record or has the ability to retire the issue if it is retractable. Call me to discuss the marketability of preferred shares and whether they are suitable to your portfolio. As always, if you have any questions about your accounts or any of the information contained in this newsletter, please do not hesitate to contact my office. Copyright CIBC, November All rights reserved. The dividend tax credit cannot be claimed for Canadian dividends received on shares held in a registered plan, resulting in taxation of dividend Preferred shares may be attractive to investors who require reliable quarterly income. Their regular income stream and priority of claim can make preferred shares

5 This article is based on information CIBC believed to be accurate on the date shown at the top of the article. CIBC and its affiliates and agents will not be liable for any errors or omissions or responsible for providing updated or revised information. This article is intended to provide general information only and should not be construed as specific advice suitable for individuals. Since a consideration of individual circumstances and current events is critical, anyone wishing to act on information in this article should consult their CIBC advisor. Your CIBC advisor cannot advise you on specific tax, legal or insurance matters. For specific advice on your circumstances, please consult a tax, legal or insurance advisor. Any references in this article to Canadian tax matters are based on federal tax laws only, unless otherwise stated. Provincial tax laws may also apply and may differ from federal tax laws. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. This document is not to be construed as an offer to sell, or a solicitation for, or an offer to buy any securities. Consideration of individual circumstances and current events is critical to sound financial planning. Anyone wishing to act on information in this document should consult with his or her CIBC Wood Gundy Investment Advisor.