Fixed Income Part 3: Preferred Shares

Insofar as fixed income goes, I have already discussed two types of “fixed” income: Bonds, and Bond ETFs. There is one more category of security that I’d like to discuss, that being preferred shares.

Overview

Unlike a bond, a preferred share is not a true form of fixed income. It is, essentially, equity. However, unlike a common share, preferred shares have many similar characteristics with a bond: they pay a fixed dividend (equivalent to a bond’s coupon payment), can have several options attached to them (such as being callable or convertible), and they rank higher than common shares with regards to a claim on a firms assets. Essentially, a preferred share (sometimes called a preferred) is a class of equity that a firm issues which has a predetermined dividend payment associated with it, which is a percentage of the preferred’s original issue price. The Bank of Montreal has several classes of preferred shares which can be reviewed here, and we’ll take a look at the Preferred Class Series 5 shares for this discussion; a copy of the prospectus can be found here.

Taking a look at the prospectus, the full name of this preferred is Non-Cumulative Class B Preferred Shares Series 5, and the preferred was originally issued with a price of $25.00, and a 5.30% yield. The 5.30% is the yield relative to the original issue price, and this equates to a $1.325 annual dividend, or $0.331250 a quarter. The preferred is also non-cumulative, which means that in the unlikely event that the BMO Board of Directors elects not to issue the dividend for a given quarter, that dividend is lost forever (explained on Page 4 of the prospectus, under the Dividends section). Reading further, the preferred share is also callable on or after February 25, 2012, at a price of $25.00/share.

Not all preferred shares are callable, or non-cumulative. For example, PartnerRe Ltd. on the New York stock exchange has Cumulative Redeemable Preferred Shares, which means that if a dividend payment is missed, the missed payments accumulate until a later date at which all dividends can be paid out to the respective shareholders. Similarly, not all preferreds are callable by their respective issuers; (non-)cumulative, redeemable, callable, etc., are all covenants placed on dividends to protect the issuer. However, not paying a dividend on a preferred share sends a very negative signal to the market. At the very least, bond holders and preferred holders should be paid out of the regular earnings of the firm, and typically common shares are the first shares to be cut.

Pros

The biggest two pros of a preferred share are their regular dividend cashflow, and their ranking on the claim of the firms assets.

For cash flow, when you purchase a preferred you are “guaranteed” the dividend payout for as long as you hold the preferred, or until the firm calls and/or converts it as outlined in the prospectus. This is what places preferreds in the category of fixed income: they provide a steady, predictable stream of income much like a bond.

In the case of callable preferreds, the preferreds also preserve much of your capital. While the BMO Preferred Share sells for slightly above its original $25.00 sell price (as of this writing, the price is $25.84, the potential of losing all of your initial investment is minimal: if the price skyrockets, the issuer will pay $25.00 if they decide to call; a 3.25% loss, but if the preferred is held for at least a year your total holding period return is still net positive (e.g. if you purchased for $25.84, after one year your total income would be $1.325; even if you sell for $25.00 your return for the entire holding period is still 1.88%). And unless the company declines to pay a dividend, the price is unlikely to fall below $25.00 a share; doing so would equate to a higher yield (as the price of the preferred falls, the yield rises); supply and demand would keep the share price at or around $25.00.

Ranking on a firms assets means that in the unlikely event of bankruptcy, preferred share holders rank below bond holders, but ahead of common share holders. In terms of paying out the shareholders who own the companies equity, after bond holders are paid, preferred share holders are next in line. This is another element of protecting your capital. Within the world of preferreds, there are still rankings (e.g., for our BMO Class B Series 5, the Class B ranks only below bonds, and covenants of the preferred dictate that the bank cannot issue another series of preferred share that ranks above the Class B), but overall there are typically less preferred shares outstanding than common shares, so you are more likely to receive a piece of the pie owning a preferred share than a common.

A final pro to a preferred is that it is more accessible to the average shareholder than a bond. One of my criticisms of bonds was that they had a high initial buy-in, typically in the $1,000 or $5,000 range. Preferreds span the gamut of accessibility and can be had for as little as $25.00 a share, definitely within range of the average investor.

Cons

Due to the covenants available for preferred shares (callable, non-cumulative, etc.), one has to be careful to read the full prospectus to understand what they are getting into when they purchase a share. For example, if you purchased a BMO Class B Series 5 in January 2013, by the time February 25, 2013 rolls around, BMO may decide to start calling the shares on the common market; your fixed income vehicle may be reclaimed by the firm before you’ve even had a chance to enjoy the dividend! Likewise, if the firm declines to pay a dividend for a non-cumulative preferred for one quarter, you have effectively lost 25% of your annual income from that preferred!

Covenants aside, one of the biggest downsides to a preferred when compared to their common counterparts are the fixed payments, which was touted as a strength above. Fixed payments essentially mean that the yield dividend of the preferred is fixed for the life of the equity, which contrasts to a common share where the dividend may rise (or fall) if EPS rises (or falls). However, it isn’t fair to compare a preferred share to a common share; while they are both forms of equity, they are completely different beasts. When analyzing the capital structure of a firm, it preferreds are often lumped in with the fixed income portion, not the equity portion. For this reason, comparing a preferred to a common isn’t a true apple-to-apples comparison.

Wrapping It All Up

Preferreds over an attractive alternative for fixed income. Their biggest advantage in my eyes is the ability to act as a fixed income stream, with relatively low initial investment. In my final post, I’ll compare preferreds to bonds and bond ETFs to see how they all stack up against each other.

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