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How to buy preferred shares: 5 simple rules

April 18, 2015 by InvestingForMe

Last month, two of our sample investment portfolio’s had their TD Bank preferred shares redeemed by the bank and so I was forced to look for a suitable replacement. In the end, I added a preferred share issued by Canadian Utilities Ltd.

 

Here are 5 simple rules that I stick to when I buy preferred shares:

  1. Interest rate forecast: The share’s features must complement my long-term outlook for interest rates.
  2. Market pricing: I look for shares that trade at $25 each or less:)
  3. Redemption feature: I want a share that’s going to stick around for a while, so I look for shares that can’t be redeemed by the issuer for at least 3 years.
  4. Credit quality: The share’s credit rating must match the minimums set out in my portfolio’s Investment Policy Statement (IPS).
  5. Diversification: I keep my investment in preferred shares to a maximum of 20% of my portfolio and I try to diversify between different companies and industries.

1) Interest rate forecast

So, the 1st golden rule I stick to when buying a preferred share is to guess what’s going to happen with interest rates. And when it comes to predicting the future direction of interest rates, I’m the first to acknowledge that no one can know for sure what’s going to happen there. But if I’m going to manage my savings and make investment decisions, including how to buy preferred shares, I still need to make an educated guess about the direction of interest rates.

Currently I don’t see interest rates going up any time soon, and so for right now, when it comes to buying preferred shares, I like shares that have the same fixed dividend payments for as long as the shares exist. These types of shares are often called perpetual preferred shares.

Note: There are other types of preferred shares that are better suited for times where interest rates look like they might rise. These types of preferred shares are called rate-reset preferred shares that have their dividend payments reset at some future date. There are also floating-rate preferred shares whose dividend payments can vary each and every quarter. But no matter what type of shares I’m hunting for, I still use the same 5 simple rules when I buy.

2) Market pricing: $25 per share

The 2nd simple rule to live by when buying a preferred share is try to buy the shares at $25 or less. And there are a few good reasons for sticking to this figure:

  • The majority of preferred shares are initially sold at $25.
  • A share’s current dividend yield is calculated by dividing the annual dividend dollar amount by $25. For example, if the share pays you $1.25 every year, then by dividing $1.25 by $25 (and multiplying by 100) tells you the share has a current dividend yield of 5.0%.
  • Finally, and most importantly, the shares will almost always have a redemption feature that allows the company to buy the shares back from you for $25. And that’s just the way the game is played, no ifs, ands, or buts! If the company wants your shares, they can force you to sell them back at $25.

Note: This forced sell back or a company’s right to exercise “the share’s redemption feature,” to use industry lingo, is one very real worry for investors. So that’s why you need to shop around wisely when you do buy preferred shares to limit any costly surprises. So, a forced sale at $25 can then be a curse or a blessing. For example, if you pay $26.50 for a preferred share, which pays an annual dividend of $1.50, only to find that the issuing company redeems the shares at $25.00 twelve months down the road, this lands you with a 0.0% rate of return before income tax, and maybe worse on an after-tax basis. But, if on the other hand, you bought the same preferred share at $24.00, then not only would you get the $1.50 in dividends, but you’d also get $1.00 in capital gains, for a 10.42% annual “cash” return, before income tax.

Remember: Price is important when it comes to buying preferred shares, and while buying cheap is great, beware of preferred shares that are too cheap. A share that trades way below $25 can also be a sign of trouble on the horizon. As a general pricing rule, if a preferred share’s market price is below $20.00, this tells you the market is worried about something and it’s probably best to avoid the share or, at the very least, make sure you dig deeper and do more research before you buy.

3) Redemption feature

The 3rd golden rule to keep in mind when buying preferred shares involves looking at a share’s redemption features.

So, as I was saying earlier, recently two of our IFM sample investment portfolios had their TD Bank preferred share investment redeemed by the bank, and I was forced to search for a suitable replacement. The reason the shares get redeemed usually involves declining interest rates and the company believes it can finance its operation by selling new preferred shares that pay lower dividends. So they force me to sell my higher paying dividend shares and make me hunt for a new preferred share investment that invariably pays less and/or is lower credit quality (which I absolutely hate!).

4) A share’s credit quality

Rule #4 is all about knowing a share’s credit quality, and while there are a lot of great preferred shares out there, there are also a lot of crappy ones.

One way to avoid poor quality shares is to restrict your search to shares issued by financially strong, high-quality companies, like those shares issued by our financial, utility and pipeline companies. For a quick and easy way to filter quality preferred shares from lesser-thans I use the share’s credit rating as measured by credible rating agencies such as Canada’s Dominion Bond Rating Service (DBRS).

Such agencies provide all listed shares with various standard credit ratings ranging from Pfd-1 (high) to Pfd-3 (low), where Pfd-3 denotes an average credit rating, Pfd-2 is a better credit rating, and Pfd-1 is reserved for the best. Personally, I like to have a minimum credit rating for the shares I want to buy, typically Pfd-3 or higher.

Note: All of the shares listed in our IFM Data Room conveniently include a share’s current credit rating. Just click on the share’s trading symbol to get a share’s credit rating, features and description.

Remember: The share’s DBRS credit rating is based upon the company’s financial strength today. It’s not a forecast for their future strength, so it’s important that you monitor the share’s credit rating on a regular basis. If the share’s credit rating declines, then you may need to make the decision to sell it or watch it more closely.

5) Diversification

So, here are a few simple diversification guidelines I use to help guide my preferred share investment decisions:

  1. Stick to a 20% limit: I limit the total amount I'll invest to no more than 20% of my whole portfolio in preferred shares.
  2. Watch your concentration: I try not to buy more than one series of preferred share issued by the same company. For example, if I’m going to own 5 individual preferred share investments, I’ll buy 5 different preferred shares issued by 5 different companies. (Note: If I like and own the common shares of a company, I am quite happy to own preferred shares of the same company. Because preferred shares are quite different from common shares, I do not consider this as doubling up or over concentrating in a single company.)
  3. Diversify by credit rating: If you’re going to own more than one preferred share, then try and have preferred shares with different credit ratings. For example, if your minimum DBRS credit rating is Pfd-3, don’t buy only shares rated as Pfd-3. Buy one or two shares that are rated at Pfd-3 and maybe buy a few higher qualities Pfd-2 and Pfd-1 shares.
  4. Look for varied dividend payment dates: If you use your investment income and you’re going to buy a few different preferred shares, then you might consider buying preferred shares that have different payment dates. This will help to smooth out your income stream. For example, you can buy 3 preferred shares that pay their quarterly dividends in March, June, September and December providing you with a great income in those particular months if your financial picture can work with that. On the other hand, you might want to buy shares with different payment quarterly dividend schedules that will provide you with an investment income spread nicely over all 12 months of the year if that suits your needs better.

Putting the 5 simple rules to work: example

So, how did I use these 5 simple rules to help me replace the TD Bank preferred shares that I was forced to sell back?

Using the 5 simple rules, I selected and added a preferred share issued by Canadian Utilities Ltd for both the Income and the Balanced portfolios. It’s official name is Canadian Utilities 4.50% Cumulative, Redeemable, Perpetual 2nd preferred share, Series DD. It trades on the Toronto Stock Exchange under the symbol CU.PR.G, and here’s how it measured up:

  1. It matches my long-term view for interest rates: The share’s main feature is that its dividends will always be $1.125 per share, per year. That means it’s called a perpetual preferred share and because I believe interest rates will stay low, it’s a match for me.
  2. It was on sale for $23.75: I wanted to pay less than $25 per share and at $23.75 the shares gave me an annual dividend yield of 4.74%. (That’s $1.125 divided by $25 multiplied by 100).
  3. I liked its 1st possible redemption: The company can’t redeem the shares and force me to sell before September 1, 2018, so I’m happy that I know I’ll have the shares for at least 3 years or maybe longer.
  4. It has a great credit rating: Even though the sample portfolio Investment Policy Statement (IPS) sets a minimum credit rating of Pfd-3, the CU.PR.G comes with a much higher Pfd-2 (high).
  5. It adds diversification: Canadian Utilities Ltd. is owned by ATCO, one of Canada’s largest utility companies, and has over 6,800 employees and $16 billion in assets. Adding CU.PR.G to the portfolios adds diversity to each.

Want to learn more?

Getting into the market to buy preferred shares requires a little research. But it’s not hard! Follow the 5 simple rules I have outlined above, and if you want to research the subject a little further, you can watch our video series IFM Videos: Preferred Shares. The videos are easy to follow and understand. There are 12 videos in all, ranging in topics from general introduction, to particular types of preferred shares, to buying and selling, etc.. So you can view them all or simply pick and choose the one that interests you most.

 

 

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