Leith Wheeler Explainer Series: Preferred Shares

Leith Wheeler Explainer Series: Preferred Shares

As interest rates began rising in late 2016, some investors, particularly taxable ones, began to increase their weight in preferred shares in place of traditional bonds. The thinking was perhaps that yield was yield, and that preferreds – being a bit of a hybrid of fixed income and equity, and so a potential beneficiary of economic growth – might somehow shield portfolios from the impact of rising rates on bond portfolios. When global equity market volatility spiked, and central banks shifted towards a more accommodative monetary policy stance, however, this thinking proved wrong. Indeed, over the past twelve months, there has been a significant divergence in performance between Canadian investment grade bonds and Canadian preferred shares as the FTSE Canada Universe Bond Index weathered equity volatility and benefitted from lowered interest rate expectations to return +7.0%. Over the same period, the S&P/TSX Preferred Share Index fell (-9.9%).

For taxable clients, we believe that preferred shares are best deployed as a tactically managed core holding within balanced portfolios and are more suitable as an opportunistic holding for non-taxable clients. However, investors must understand that preferred shares present different risk characteristics from traditional bonds and should therefore be wary about using preferred shares as a proxy for bonds within their fixed income allocations.

Figure 1: Divergence of Performance Between Preferred and Fixed Income Securities (12 months to June 30, 2019)


The Case for Preferred Shares

Much like a bond, preferred shares are rated by major credit rating agencies and are issued at a par value with a pre-determined distribution rate and payout dates. Preferred shares rank below bondholders but sit above common shareholders in their claim to distributions and liquidated assets in cases of bankruptcy by the issuer. Preferred shareholders are compensated with a higher dividend yield versus bondholders, but participate less in the upside than common shares when the issuing company increases in value.


Seniority to Asset Claims


Credit Rating


Capital Appreciation Due to Company Value Growth





Semi-Annual Interest Payment


Preferred Shares





Quarterly Dividend, After Bond Interest Payment is Paid


Common Shares





Optional Dividend, After Bond Interest Payment and Preferred Share Dividend is Paid


Distributions for preferred shares are issued and taxed as dividends (like common shares) rather than interest income (like bonds). This distinction typically generates a higher after-tax yield for investors, particularly for those who pay a high tax rate. As a portfolio management tool, preferred shares also provide returns that have a low correlation with other asset classes and therefore provide positive diversification effects. The bond-like attributes, favourable tax treatment of dividends, and diversification benefits make preferred shares an attractive option for taxable, income-oriented investors.


Should Preferred Shares Replace Bonds to Generate Extra Yield?

Our short answer is no. While we believe that there are a number of positive reasons to own preferred shares, it remains a separate asset class from traditional, investment grade bonds and possesses a unique risk and return profile. Here are some differences to consider:

1. Despite their bond-like features, preferred shares do not have a maturity date. A bond investor knows exactly when they will receive their principal back, barring an issuer default. A security with a maturity date, particularly as it approaches, has the effect of dampening volatility.

2. Credit risk, or the credit worthiness of the issuer, impacts the price return of preferred shares more than traditional bonds. Because preferred shares are subordinated to bonds within the capital structure, if the issuer goes bankrupt, preferred shareholders are only compensated after all creditors are paid out. The credit risk of preferred shares more resembles high yield bonds, and both have historically experienced higher volatility than traditional bonds. In a typical balanced portfolio, bonds provide a stable yield and more importantly act as an offset to the higher volatility in equities – both common and preferred. Reducing bonds in favour of preferred shares provides higher yield, but with more volatility so the ride will be much bumpier.

3. One of the reasons for the higher volatility is the rise of passive investment in preferred shares. Each issuance of preferred shares is unique and includes different features including callability by the issuer, convertibility to common shares, coupon rate provisions and policies around whether missed dividends are accumulated. Because of the complexity of some of these securities, many investors choose to invest in preferred share mutual funds or exchange-traded funds (ETFs), which have proliferated in recent years. The implication of fund flows to passive investment products like ETFs is that they can exaggerate market movements, particularly in a small market like preferred shares with issues of around $60 billion compared to the approximately $600 billion market for Canadian corporate bonds. Investors, therefore, need to consider the liquidity constraints of the preferred share market and whether that is suited for their fixed income allocation.

4. When investing in a preferred share fund, it is also critical to understand the composition of the underlying holdings. Over two-thirds of the preferred shares outstanding in Canada are “rate reset” preferred shares, which pay investors a fixed five-year coupon comprised of the five-year Government of Canada bond yield and a spread (premium) based on the credit worthiness of the underlying issuer. At the end of the five-year period, the coupon for the preferred share is “reset” with the prevailing five-year Government of Canada bond yield plus the spread. As an example, if interest rates five years from now are higher, then your preferred share will reset at a higher coupon rate that will be in place for another five years.

Most preferred share funds available to investors today will be heavily weighted in rate-reset preferred shares, meaning that the sensitivity to interest rate movements is the opposite that of a typical bond or bond fund. Rate-reset preferred shareholders would modestly benefit when interest rates rise, and underperform when interest rates fall. The opposite is true for traditional bonds where it will see gains when interest rates fall and losses when interest rates rise.

Equity markets were under significant pressure at the end of 2018 as the prospects of slower growth due to global trade uncertainty, flat yield curves, and weakness in energy markets triggered a reassessment of asset valuations. The S&P/TSX Composite Index fell (-10.1%) in the fourth quarter of 2018 and the S&P/TSX Preferred Share Index returned (-10.0%). While equities recovered from the selloff, preferred shares continued to weaken as interest rate expectations fell and the Government of Canada 5-year yield moved from 2.05% to 1.40% over the one-year period ending June 30, 2019. Balanced portfolio investors who leaned on their bonds holdings to dampen portfolio volatility would have fared much better versus portfolios that used preferred shares as a bond proxy.

Preferred Shares at Leith Wheeler

While passive investment products can exaggerate market movements, we believe that it also creates opportunities for active managers who take a bottom-up, fundamental approach to investing to navigate through the noise to look for undervalued investments. For taxable clients, preferred shares are best suited as a tactically managed core holding in balanced portfolios. Valuation based on after-tax yield makes preferred shares compelling relative to comparable income-generating asset classes such as high yield bonds.  However, non-taxable clients, who do not benefit from the favourable tax treatment of preferred shares, should require a higher threshold to invest. As such, our preferred share investment approach for non-taxable clients has been opportunistic when relative valuation is attractive.

Our team seeks to adds value in preferred shares in three primary ways:

  1. Credit Valuation – We use independent, fundamental credit analysis to determine the relative valuation between issuers. This is the same approach that we take with our fixed income analysis.
  2. Preferred Share Valuation against Bond Equivalent – We create a valuation model to compare spreads of preferred shares against their bond equivalents to exploit systematic mispricing due to ETF flows, retail investors, and non-economic decisions by the market like an over-emphasis on yield.
  3. Asset Class Valuation – We apply a valuation model at the asset class level, which guides our allocation decision. This is the framework that we use to determine our preferred share weight in our two income funds, the Leith Wheeler Corporate Advantage Fund and Leith Wheeler Income Advantage Fund.

The low interest rate environment has been difficult for investors requiring income generated from their investment portfolios, and so it’s understandable that preferred share yields have attracted interest. But there are always risk and reward trade-offs when reaching for higher yield and the risks are not always obvious. We believe that the best approach to investing is sticking with a disciplined, bottom-up process to find undervalued investments. And understanding how preferred shares behave within your broader portfolio is an important first step.