Wouldn't it be great if investments came with a rating like a ski run?
November 7, 2015 by InvestingForMe
Just imagine! Then you’d know what you’d be getting yourself into with just a quick glance! You’d know if you’re going to be somewhat comfortable, or on the other hand, way in over your head! Wouldn’t that be handy? So, let’s borrow from the ski resorts and use their rating system to talk about a few preferred share investment opportunities.
Preferred shares: 4 great investment opportunities
The last year has been a tough one for investors. Bonds, stocks and preferred shares are all down in value. So, for some investors it’s a stressful time as they watch their investments take a nosedive, while for others it’s a time to buy into fresh opportunities created by the current market weakness.
And so it is in the market of preferred shares. Right now the recent drop in share prices has created 3 potential investment opportunities that you could be taking advantage of – some suitable for beginners and others more appropriate for the more experienced and even expert investors:
|1. For Beginners (with little or no experience investing in preferred shares): buying newly created Rate-Reset preferred shares that now come with a fixed minimum dividend rate.|
|2. For preferred-share investors with some experience: buying over-sold Rate-Reset preferred shares|
|3. For the Experienced preferred share investors: making the switch, that is, selling one Rate-Reset preferred share and buying another, more attractive one.|
|4. For the Expert: finding and buying deep value, preferred share investments with the potentially fat returns offered by a few beat up companies and their Fixed-Rate preferred shares.|
So, before we get into the first category listed above (or the bunny-run equivalent of preferred shares), let’s just review some of the basic principles when it comes to discussing preferred shares. (Note: If you’re an experienced preferred share investor, you can skip this minor review.)
Understanding preferred share market prices
If you’ve never invested in preferred shares, then it’s important to quickly familiarize yourself with the following 3 main forces that affect a preferred share’s market price:
- The direction of interest rates. This is a very simple concept. In general, if interest rates go up, then you can expect the market price for your preferred shares to go down. And if interest rates go down, then you should expect the share’s market price should go up. (Pretty straightforward stuff!)
- A share’s credit rating. Most companies that borrow from investors (by selling bonds, preferred shares, etc.) often have their financial strength reviewed, assessed, and assigned a credit rating to their investments by an independent credit rating agency. So, when a preferred share’s credit rating is changed, the share’s market price will also often change. In general, if a share’s credit rating is raised, then its market price will often go up. And the opposite is also true. If the credit rating declines, then you can expect the share’s market price to decline as well.
- A share’s features. If a share has a special feature that can alter the share’s characteristics, the preferred share’s market price will go up or down depending on the impact of investors’ dividend yield. For example, the market prices for most Rate-Reset preferred shares have taken a tumble because they’re having their dividend payments reduced when the shares’ dividend rate-reset feature kicks in.
Note: Stock markets will often anticipate changes in interest rates and a share’s credit rating in advance, and a preferred share’s market price will often adjust in advance of the changes actually occurring.
Ok, so getting back to our ski resort sign category analogy, let’s look at that first type of preferred shares.
Rate-Reset preferred shares with a fixed minimum dividend rate
Often when an investment’s market price gets beaten up, as it has for Rate-Reset preferred shares, companies want investors to keep buying, so they sweeten the investments appeal by adding new features. And that’s exactly what’s happened with the introduction of a new type of Rate-Reset preferred with a fixed minimum dividend rate.
In the past, when investors bought a rate-reset preferred share, they accepted that at some point in time the dividend rate would be reset according to a formula that relied on the current yield of a Government of Canada 5-year bond. The assumption, at the time of purchase, being that interest rates would eventually go up and future dividends would be reset at higher and higher rates. Most investors never contemplated that interest rates wouldn’t go up and the rate-reset shares would actually pay a dividend rate less than the initial rate, but that’s exactly what has happened. As a result, as the dividend rates were reset to lower rates, rate-reset preferred share market prices dropped – and dropped hard.
As a result, lots of investors, still hurting from their rate-reset losses, have sworn off ever buying another rate-reset preferred share ever again. And as you can imagine, this has created a real problem for companies that want to finance their activities by selling preferred shares.
However, investors are still convinced that interest rates are going to go up, so they want the preferred share’s dividend rate to also increase when it happens. But they don’t want to repeat past losses if interest rates don’t go up. So the investment industry has come up with a new type of preferred share that gives investors everything they want – a Fixed Minimum Rate-Reset preferred share.
Basically, it’s the same old rate-reset preferred with a bonus feature – a fixed minimum annual dividend rate. In other words, they’re a more safe way to invest in preferred shares. And so far, 2 companies are offering this kind of share:
A great new opportunity
This new breed of preferred share just might be a great option for those just heading out to the ski hill for the first time (so to speak), and for those experienced investors that want the safety of a fixed minimum yield. They provide investors with 2 big advantages:
- Interest rate protection: This new breed of preferred share offers you the best of both interest-rate worlds. If interest rates do go up in the future, then your share’s dividend rate will also go up. But, if interest rates stay at current levels, or go down, your dividend rate will not go below the fixed minimum rate. (Talk about a win/win for investors! No more guessing about the direction of interest rates!)
- Market price protection: By having a fixed minimum dividend rate, with all things being equal should interest rates decline further, the market price for this new breed of share should stay the same or even go up. In other words, the share’s market price won’t fall victim to that old pattern of hurt that many investors experienced with the old style of rate-reset preferred shares.
So, they kind of sound attractive, don’t they, in a safe kind of way? Well, these new breed of shares are just one of the current preferred share investment opportunities - great for beginners.
Next week we’ll delve into the second opportunity available for the investor with some experience with investing in preferred shares - Buying over-sold Rate-Reset preferred shares in today’s market
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