This is a column from regular contributor Clark.
Preferred shares have their pros and cons when compared to common stocks and bonds, and there are various types available. This edition will look at some selection criteria worth considering when buying preferred stocks.
As discussed in the corporate bond series and credit ratings, credit agencies also issue ratings for preferred stocks. DBRS, Moody’s and Standard and Poor’s are good places to look for these ratings. Please note that Moody’s and Standard and Poor’s require registration (free) to access their vast database. It would be prudent to cross-check ratings at two or more agencies and use the lower rating if they differ. However, the credit rating terms may differ across agencies, i.e., Pfd-1 at DBRS is equivalent to P-1 at Standard and Poor’s.
Some Relevant Metrics
Current Yield = Annual Dividend Amount / Current Preferred Stock Price
It is worth noting that current yield oversimplifies calculations by disregarding redemptions and retractions. E.g. an investor buys a preferred share at $20 enticed by a current yield of 7.50% (annual dividend amount of $1.50). If the stock is called by the company soon after for $17 as set in the prospectus, then the investor faces a capital loss of $3 per share and left without any of the high yield that he had bought the stock for!
Yield-to-maturity. The rate of return of the preferred stock when held for its full term (until maturity) – valid only for retractable issues.
Yield-to-call. This refers to the yield of the preferred stock when held until the call date. Evidently, the metric is valid only if the stock is called prior to maturity. The yield is calculated as a function of the dividend rate, call price and date, present stock price and time until the call date.
Yield-to-worst. As the name indicates, this metric considers the worst-case scenario and computes the yield for such a case. If the preferred share can be called over a period of several years with a decreasing premium as outlined in the prospectus, then the yield-to-worst becomes significant. Yield-to-worst is determined for all possible call dates and also considers the call or put options included in the stock.
A few online resources that provide the above data will be included in the next (final) part.
Impact of Preferred Stock (on the company)
From a corporate viewpoint, although preferred shares are similar to bonds in making fixed payments, there is the advantage that preferred share dividends can be suspended, whereas failure to meet bond interest payments would be default on its debt obligation. Bond interest is paid with pre-tax dollars of the company, whereas dividends – preferred and common – are funded with the company’s net income, i.e., profit after tax. Outstanding preferred shares are not shown as debt on financial statements and hence, they may not have a negative impact on future credit applications. The company may be able to get a lower interest rate due to lower debt.
Taxation (for the investor)
Since many preferred dividends are taxed favorably in a non-registered account (assuming they are eligible dividends and not capital gains or return of capital), they offer the same tax advantages as common share dividends. Preferred shares are best used when held in such taxable accounts rather than in an RRSP or TFSA, where the tax shelter eliminates the tax favors from the CRA.
About the Author: Clark is a twenty-something Saskatchewan resident employed in the manufacturing sector. He repaid around $20,000 in student loans and has been working to build his investment portfolio as a DIY investor (not trader) while nurturing plans to retire early. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).