Preferred stocks are popular among investors seeking a purely financial stake in a company. A preference share is distinguished by the fact that it contains company shares but lacks a right to co-determination. Similar to common shares, preference shares are issued when a corporation’s capital is increased and are traded on the stock exchange. You can find the prices of preferred stocks on the relevant stock exchange. Additionally, stock exchange information services provide data on the price evolution of preferred shares.
Here are 5 simple rules that I stick to when I buy preferred shares:
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.
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:
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.
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!).
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.
So, here are a few simple diversification guidelines I use to help guide my preferred share investment decisions:
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: