In the previous issue of Strategies (May 2017), T.E. Wealth examined the possibility that the decades-long bull market in bonds might be coming to an end. Long story short, having touched 35-year lows last September, yields seem to be on the rise. Indeed, in mid-June, the U.S. Federal Reserve raised its overnight interest rate for the fourth time since the global financial crisis ended. For its part, the Bank of Canada raised interest rates by 25 basis points this past July, and some speculate that rates could climb further before the end of the year.
If interest rates are in fact in the early stages of an upward trend, this presents a problem for bond investors, as bond prices fall when interest rates rise. Moreover, given that rates have been so low relative to history, it would not take much of an increase in rates for capital losses on bonds to exceed the interest payments received by an investor.
No one can know, except with the benefit of hindsight, whether the long-term bond bull market is over. That said, it may be prudent, especially for yield-oriented portfolios, to consider bond alternatives. One of those alternatives is preferred shares.
A quick recap of what exactly preferred shares are might be useful: as their name implies, preferred shares rank ahead of common shares in a company’s capital structure. What this means is that preferred shareholders must receive their dividend payments before common shareholders are paid. However, preferred shares still rank below a company’s debt obligations. Given their nature, preferred shares are often characterized as hybrid investments, part equity and part fixed-income.
So, why may now be a good time to consider preferred shares? For one thing, preferred shares provide a much higher yield than bonds or common shares. Investors can earn close to 5% before-tax on the S&P/TSX Preferred Share index, versus a 1.4% pre-tax yield on a benchmark 5-year Canadian government bond (data as of June 30). Also, preferred share dividends are subject to a preferential income tax rate compared to bond interests, which results in an even larger yield spread after tax. Relative to history, preferred shares also seem attractively priced compared to government bonds. When they were first issued several years ago, these securities typically paid investors about 1% over the 5-year Canada bond yield. Now, however, given that government bond yields are so low, the spread has ballooned to about 3%. Preferred shares also handily provide a much better yield than common shares: the pre-tax dividend yield for the S&P/TSX Index is just shy of 3%, by comparison.
There’s another reason to believe preferred shares might currently present a compelling alternative to traditional fixed-income investments. While fixed-income products suffer when rates are on the upswing, the composition of today’s preferred share market means that they actually could do quite well in such an environment. Rate-reset preferred shares now make up over two-thirds of the Canadian market. This kind of preferred shares “reset” to a higher dividend when government bond yields rise, so if the era of ultra-low interest rates is truly behind us, they should provide higher income streams for investors in the future.
Finally, there’s the simple fact that preferred shares have not enjoyed the sort of performance of other asset classes. As of June 30, Canadian preferred shares have only provided a total return of just over 6%, whereas the FTSE/TMX Canadian Bond Universe has returned nearly 18% and common shares, as measured by the S&P/TSX Composite index, show a total return of 52% over the last five years. Conceivably, the coming years could see this gap in performance start to close.
Whether an increased allocation to preferred shares is right for you will depend on many factors, such as your current exposure as well as your risk tolerance. Talk to your investment counsellor about the role these stocks could play in your portfolio as a diversification from traditional fixed-income investments.
Andrew Hepburn is a freelance financial writer and journalist based in Toronto. He’s written for the Globe and Mail, Maclean’s, and Morningstar, among other publications.
This article was published in T.E. Wealth’s Strategies newsletter, September 2017 edition. Read the full edition here.