In the investment Q&A at 5i Research, we often get many investment questions on the merits of preferred shares. It is a fairly popular asset class in Canada, and who wouldn’t like a 4% to 5% tax-efficient ‘income’ stream? The big problem with preferred shares, in our view, is that investors often do not fully understand what they are getting into. Many think they are getting the best of both worlds when they may actually be getting the worst of both worlds.
We think some of this stems from the title of the asset and specifically, the ‘share’ aspect. When investors think shares, they often (and rightfully so) think growth and capital gains. This is probably why many investors wonder if and when they will make back the capital on a preferred share bought at a premium. If the stock of the company is doing well, the preferred share should as well, right? Unfortunately, not quite, and this is one of a few reasons we are not huge fans of preferred shares and hybrid securities in general:
More risk, less return?
This is our main qualm with the asset class. When you own a preferred share, you assume more credit risk than you would with an equivalent fixed income product and give up the growth potential that could be gained from ownership of the stock. There is no assurance that you will get your capital back on a preferred share and this is an issue that many investors tend to miss. Preferred shares are generally not like bonds where they have a maturity date that the company is forced to pay back the capital. Preferred shares can actually trade indefinitely and even trade at a discount to the issue price for long periods of time. While an investor has more credit risk due to the priority of creditors over preferred shareholders in a bankruptcy situation, you do not share in the same success that the common shares may have as you do not really have a claim on the earnings of a company like common shareholders do. Investors are only entitled to the distribution that is predetermined upon the issue of the security. So what you get is an awkward stepchild that misses out on the benefits of being either a stock (growth/capital gains) or a bond (protection of capital). In addition, except in rare cases, the extra security of a preferred often does not add up to much. When a company gets ‘in trouble’ preferred shares are typically wiped out along with common shares.
Twice the knowledge:
Preferred shares are a fairly simple security to value but understanding what is going to drive the price in the future is very difficult because you need to often be right both on macro trends (interest rates) and company specific trends (credit quality, financing decisions). A bond in the right ‘rate environment’ with a company stock that lags, can do just fine. Alternatively, a stock can perform well while the bonds flounder. You only need to be right on one asset class driver (yes this is a simplification). With preferred shares, however, an investor needs to understand how the asset class will perform relative to interest rates (relative attractiveness of yields) as well as the long-term prospects of the company going forward and its ability to maintain dividends. Remember, this is not like a bond where you get to ‘cash-out’ and get your money back in ‘X’ years upon maturity. These securities could be active for the duration of the companies’ existence. On top of all of this, investors need to know the specific details on each issue they are investing in, as preferred shares have various structures with different dates, options and yields. Finally, data is scarce and tough to find in any efficient manner on the asset class as a whole, adding to difficulty and time required.
So when, if ever, do preferred shares make sense? We think preferred shares can make a lot of sense in a portfolio for diversification and as long as you understand what you are getting into:
Own for income:
There is no free lunch with investing, aside from maybe the power of compounding. Preferred shares sound like they offer a great combination of growth and income but the reality is that one is sacrificed for the other in investing. We think preferred shares make the most sense when an individual simply needs a tax efficient income stream, and the income stream alone. In other words, the investor could deal with the invested capital declining to essentially zero, as long as the income is maintained to meet whatever the cash flow needs are. Preferred shares can make a lot of sense when you need cash flow, but do not need the capital.
Below is a chart showing the correlation of the TSX preferred composite (CPD) to the TSX composite and to a Canadian universe bond index (XBB). It is clear that there are diversification benefits with owning the asset class, it just becomes more difficult to defend when the diversification cost investors 21% over 10 years! With that said, we almost always side with diversification and would be reluctant to use past performance as a reason to not own an asset class. This gets investors into the classic issue of chasing returns and part of the reasoning behind diversification is that you just do not know when an asset will or will not perform, so why not have a bit of exposure to a range of asset classes?
*Green = XBB, Purple = TSX, Orange = CPD, Start date = Oct. 12, 2007
Upon further examination of the above chart, however, there is a really interesting trend we have noticed. The correlation of CPD to both the TSX and to XBB is materially negative (-.84 and -.54 respectively). In previous periods where correlations were this negative, they have tended to snap back and if this occurs, a stronger bond and stock market could mean better preferred share performance if the correlations reverse. Investors do need to consider the potential issue of a ‘regime change’ in a fund like CPD with the introduction of rate-reset securities, making historical correlations less useful. Also, the lower that the asset class goes, the higher the yields rise and at some point, one would think that income/yield investors will start stepping into the asset class, adding to demand and breathing some life back into these securities. There is not assurance it will actually happen (there never is) but it is an interesting divergence to keep an eye on nonetheless.
We believe preferred shares can have a place in an investors portfolio but before putting hard earned capital at risk, it is important that investors understand the reasons why they are purchasing or need the securities and understand the unique features of the security and/or asset class.