February, 2024
Derek Frail, CIM®, FCIA
Quality issuers of preferred shares have a very high likelihood of meeting both their bond and preferred share commitments.
Preferred shares have always endured extended periods of neglect, defying conventional assessments of their fundamental value. Their prices have exhibited downside pressure during both good economic periods and in downturns, often leaving market experts puzzled attempting to explain the underlying source and extent of selling. Despite inevitable upward movements in prices, it is understandable why investors and their advisors can lose their appetite for investing in this asset class. We want to consider whether the price volatility should prevent an allocation to long-term investment portfolios.
At their core, preferred shares are straightforward investments. They represent a promise by the issuer to pay a quarterly fixed, or periodically varying, dividend with no maturity date. Preferred shares are similar to bonds in that they represent a contractual promise to pay income as long as the issuer is financially able to do so. But they have fewer rights than bond holders and therefore are riskier investments than bonds. Quality issuers of preferred shares have a very high likelihood of meeting both their bond and preferred share commitments. Instances of investment grade issuers not paying scheduled dividends have been rare in the Canadian market.
The primary cause of excess volatility in the preferred share market is low liquidity, a key measure of which is the volume of trading activity. The market itself is small in scale so it does not attract deep pools of capital. In the primary preferred share market, individual issue sizes are relatively small, with large proportion of those issues often being held by institutions that do not trade the securities. The result is low trading volume in the secondary markets where investors trade their shares. There are two important conclusions from illiquidity. First, only allocate capital to the preferred share market that you do not need to meet your near-term cash needs, the market price is highly uncertain in the short term. Second, take advantage of the price volatility, most often it does not stem from a fundamental change in the issuers ability to pay dividends.
Price volatility is what you get but what do you receive? We think it best to consider expected preferred share returns relative to the return on bonds, most often by using Government of Canada bonds as the benchmark for a safe alternative investment. The relative value, represented by the expected income yield on a preferred share compared to the yield on a safe bond, is the primary way to fundamentally value the preferred share market at any point in time. Recently one could invest in a Government of Canada bond and receive 3.5%. This compared to investing in a diversified mix of investment grade preferred shares and receiving a 7.5% dividend. That 4.0% extra return is attractive compensation for the risks of non-payment of dividends, illiquidity, and indeed for the price volatility.
The right action after a large price decline is to allocate more capital to the asset class. The right action after a large price increase is to reduce some of the capital allocated to the asset class. Knowing non-fundamental price volatility will happen, it is best to use that volatility to your advantage.
There are other potential benefits to preferred share investment. The dominant structure in the Canadian market features dividends that adjust periodically with interest rates, that means your income over time would adjust to help keep pace with adverse inflation. If you are a taxable investor, investing outside of your registered accounts (like RRSPs and TFSAs) the dividends on the preferred shares are taxed at a lower rate than is interest income on bonds. That added attraction can make them ideal for long-term investing of personal taxable funds or for savings inside a private corporation.
We think the returns on preferred shares justify allocating a portion of our long-term client capital to them. The expected returns are excellent, and their price volatility often is not correlated with other asset classes, thus enhancing portfolio diversification. While we acknowledge the inherent price volatility, we view it as an opportunity to add value to long-term portfolio return.
Author:
Derek Frail, CIM®, FCIA is a Portfolio Manager with Louisbourg Investments. Comments or questions may be submitted to Derek at derek.frail@louisbourg.net.
More articles from Louisbourg Investments:
This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. If you are not sure how to proceed with a request for further information, seek help from a professional. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments.