Love dividends? Don't overlook beaten-down preferred shares

Preferred shares can offer reliable income with the advantage of preferential tax treatment because the payout is structured as a dividend instead of interest income. THE CANADIAN PRESS/Nathan Denette (The Canadian Press)

Yield-hungry investors may want to take a serious look at the beaten-down preferred share market as some risks start to fade into the rearview mirror, according to money managers.

"A lot of the systematic and idiosyncratic risks we're seeing in the market are starting to kind of clear up. Couple that with a pretty good backdrop of where the Canada five-year [government bond] is currently priced, we think it's a pretty good opportunity to buy many of these preferred shares in the Canadian market," Jeremy Lin, portfolio manager at Purpose Investments, told Yahoo Finance Canada via phone.

Some of the risks he's referring to are interest rate risk, concerns about the banking sector after the collapse of three regional U.S. lenders, and the U.S. debt ceiling crisis.

However, he says it's best for investors to move in slowly.

"Given the space is a little bit more illiquid and we're still seeing rate volatility today, it makes sense to spread out your entries. But we definitely see that now is a good time to start adding to the position," Lin said.

The rapid rise in interest rates battered many areas of the financial market but preferred shares were hit particularly hard. The S&P/TSX Preferred Share Index is down roughly 20 per cent over the past 12 months, underperforming the broader TSX Composite, which is down about five per cent over that timeframe.

"But if you just sort of take a blank slate and say, hey, is there an opportunity to buy something in the preferred share market that you think is probably going to be a pretty good investment? The answer is yes," said Ted Rechtshaffen, president and chief executive of TriDelta Financial.

Pros and cons of preferred shares

Preferred shares have both equity and fixed income elements. They trade like stocks, represent ownership of a company, provide a regular payout and have a par value, similar to bonds. There are two main types: straight preferred shares pay a stable dividend forever, and rate reset shares, which have a dividend that resets at specific intervals (typically five years).

Preferred shares are usually offered by blue-chip companies so the credit quality is relatively high, the yields are attractive and the payouts get preferential tax treatment since they're in the form of a dividend and not interest like a bond.

Rechtshaffen says another advantage is that the dividend on preferred shares can't easily be cut, unlike common stock, which can be subject to surprise reductions or have the payout eliminated altogether.

On the downside, preferred shares are more illiquid compared to common stock. Because of the lower liquidity, Rechtshaffen suggests using a limit price order when buying or selling these securities, which executes the trade at the specified price, instead of a market order, which completes the trade at the current market price. This will help avoid overpaying or selling below an investor’s desired price.

Their price also moves more in tandem with interest rates, not the common share price, and the moves up or down can be more significant.

Opportunities in preferred shares

"We've been more active in repositioning our portfolio there, just given that we're starting to see some more opportunities pop up in the preferred share space. I'd say we're probably a little bit more active today versus before," said Lin.

One he likes right now is Brookfield Corporation rate reset preferred shares (BN-PFB.TO), which are owned in client funds.

He says the share price has been under pressure because of concerns over the company's office real estate exposure but overall, the company is still diversified and he's not worried about its credit quality.

Meanwhile, Rechtshaffen says he likes George Weston straight preferred shares (WN-PD.TO) because investors can own a "safe company from a Canadian perspective and it's paying a dividend of 6.25 per cent." He owns them personally and in client funds.

Another option he likes is Great-West Lifeco preferred shares (GWO-PR.TO), which are fund-owned.

"Similar to Weston, it's something that has a pretty good dividend yield from a solid company that we think as interest rates start to come down a little bit, these will start to look more and more appealing. And the price has been beaten up a little bit," he said.

Michelle Zadikian is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.

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