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Want to earn 5% without the risk of stocks? Meet preferred shares

Preferred shares can have a place as an income-generator in Canadian portfolios (Getty)

A side effect of persistently low-interest rates is that most savings accounts earn you next to nothing, while government bonds pay a pittance and investment-grade corporate bonds pay only slightly more.

The stock market is a riskier bet and far more volatile. So where do investors turn? It might be time to consider preferred shares as part of your portfolio.

A basket of Canadian bonds, like the iShares Core Canadian Universe Bond Index ETF (XBB) gets you about 2.4 per cent in interest payments over the course of a year. The iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) gets you about 5.1 per cent in dividends.

Preferred shares won’t go up in value like common shares but the ride is much smoother.

“The S&P/TSX Preferred Index has an annualized return standard deviation of 11% compared with 17% for the S&P/TSX Composite since 2002, so roughly two-thirds volatility observed,” Sandy Liang, portfolio manager and head of fixed income at Purpose Investments, told Yahoo Finance Canada.

Preferred shares are something of a middle of the road asset class. They are safer than stocks but not quite as stable as bonds.

If a company goes belly up, bondholders get paid first followed by preferred shareholders, then common shareholders. Employees, suppliers, creditors, and tax collectors get the scraps.

Instead of the interest payments, you would get from bonds, preferred shareholders earn dividends which are eligible for the dividend tax credit when held outside of tax-sheltered accounts like RRSPs and TFSAs. Interest from bonds is fully taxable as income.

Liang says only five major Canadian corporations have missed payments in the last 30 years and all were rated below investment grade.

There are currently around 70 Canadian companies issuing preferred shares. Some of Liang’s favourites are TransCanada (TRP.TO), TD Bank (TD.TO), Royal Bank (RY.TO), Manulife (MFC.TO), and Brookfield Asset Management (BAM-A.TO).

Brian Madden, Senior Vice President at Goodreid Investment Counsel, calls preferred shares ‘alt-fixed income,’ and holds them for income rather than capital gains.

There are two types of preferred shares.

“Rate-reset prefs will re-price their dividend every five years at the then prevailing 5-Year Government of Canada bond rate, plus a spread, so this is good protection against rising interest rates,” Madden told Yahoo Finance Canada.

“For investors expecting falling interest rates, perpetual prefs never mature, and pay a fixed dividend, which might today yield, 4.5 – 6%, for instance, which looks very compelling if all of a sudden interest rates fall back towards zero…these issues can generate decent capital gains in falling rate environments.”

That works both ways though. When the Bank of Canada unexpectedly cut interest rates in 2016 the value of rate resets tumbled.

There are also liquidy risks because the market is so small. Madden says the total value is around $80 billion, which is less than the value of CN Rail (CNR.TO). Institutions tend to stay away leaving the market to the whims of retail investors.

“Any little tremor in the marketplace can sometimes in the short term cause a reaction akin to someone yelling “FIRE!” in a crowded theatre…a disorderly, panicky exit, with very limited amounts of professionally managed capital to act as an offsetting stabilizer,” says Madden.

Jessy Bains is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jessysbains

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