Investing in Preferred Shares

Advantages

Tax Advantaged Investment Income.

The main reason to invest in preferred shares is for investment income. Preferred shares pay higher dividends than most common shares and provide investors with a tax advantaged source of income that, in some cases, offers a better yield than bonds of similar credit quality and risk. Also many of the recent issues in the structured or split share category offer a variety of tax-efficient distribution types to benefit investors across all tax brackets.

Security of Principal.

Greater security of principal may also motivate investors to invest in preferred shares as they rank ahead of common equity in the payment of dividends and in the distribution of assets in the event a company is liquidated. In addition, preferred shares’ dividend payments are often “cumulative”, which means that dividends accrue to the holder of the preferred share if the issuer misses a payment. The issuer must pay the missed dividend before any dividends are paid on common shares.

Lower Price Volatility.

The majority of term preferred shares have five or 10 year maturities. Shorter maturities are less sensitive to changes in interest rates than corporate bonds, which generally have longer terms. However, this cannot be said of perpetual preferred shares, which, due to their long duration are quite sensitive to changes in interest rates.

Exchange Traded Markets.

Unlike bonds, preferred shares trade on public exchanges where the bid and ask prices are visible to all market participants. This is an advantage for income investors as it provides greater transparency and efficiency in pricing.

Risks

Interest Rate Risk.

Preferred shares are income investments whose yields and prices vary with the general level of interest rates. Investors in term preferred shares (i.e. those with a fixed maturity date) will lock in a rate of return upon the purchase of a preferred share but will be subject to reinvestment risk on dividends earned and once the principal is paid upon maturity. Investors in perpetual preferred shares are exposed to a greater degree of interest rate risk due to the fact that their investment principal need not ever be repaid.

Credit risk.

Credit risk involves any change in the creditworthiness of the preferred share issuer. The creditworthiness of an issuer refers to its general financial strength, including its ability to pay dividends and repay principal on maturity. The credit quality of preferred shares in Canada is monitored by two independent credit rating agencies: Dominion Bond Rating Service (DBRS), and Standard & Poors (S&P). Investors can consult these two agencies to assess the credit risk of investing in the preferred shares of an individual company.

Exchange-Traded Funds

The past several years have seen the rise of a new type of mutual fund that is changing the way many Canadians invest. Exchange-traded funds (or ETFs) are open-ended mutual funds that are listed and trade on a stock exchange. There are a wide variety of ETFs available to investors, ranging from funds based on well-known stock indices to those focused on individual sectors. ETFs are unlike traditional mutual funds in that a portfolio manager does not actively manage them. Instead, they have a static portfolio that is overseen by an administrator. Buying an ETF is identical to buying a publicly traded stock where investors purchase units at any time during the trading day from current holders who wish to sell. This differs from traditional mutual funds where units are bought and sold at the end of the day directly from a mutual fund company. ETF units can be redeemed for cash or the underlying securities held by the ETF, however the primary market for ETFs is on a stock exchange.

Advantages of Exchange-Traded Funds

Diversification. Exchange-traded funds provide portfolio diversification through a single security. For example, an investor who buys a unit of the S&P/TSE 60 Index Fund gains exposure to the sixty different stocks held by the fund. This allows smaller investors to gain diversification quickly and easily.

Portfolio Flexibility. Exchange-traded funds allow investors to adjust their portfolio exposure between different markets and sectors through a limited number of securities.  For example, an investor wishing to increase U.S. equity exposure can simply purchase the S&P Depository Receipts (SPDRs), an ETF based on the S&P 500 Index, through a single transaction.

Lower fees. Fees for ETFs tend to be much lower than those for comparable mutual funds and this can contribute to higher returns after fees. For example, the management expense ratio (MER) for i60 units is 0.17% compared to fees of 0.80% to 0.90% or higher for most Canadian index mutual funds.

Liquidity. ETFs can be bought and sold at any time during the trading day on a stock exchange. This allows investors to take advantage of any intraday price fluctuations.  Trading volumes tend to be good for more popular ETFs. For example, trading of i60 units averages over 2 million units daily.

Tax Efficiency. ETFs that track an index change their portfolio holdings only when there is a change in the underlying index. This means lower turnover than actively managed mutual funds and less taxable distributions at the end of the year.  EFTs pay out dividends and the investor receives a dividend tax credit, increasing their overall income gained.  Mutual funds pay out interest income and the investor is taxed 100 percent of their marginal tax bracket, thus reducing their overall income.

Small Cash Positions. Because investors buy and sell them in the market, ETFs do not need to hold large cash positions to manage redemptions. This means more money is invested in the underlying portfolio at any given time, which enhances returns.

Risks of Exchange-Traded Funds

Liquidity Varies. Average daily trading volume will vary widely between different exchange-traded funds. While some trade millions of units a day, others may only trade several thousand units.