Demystifying the economy | How do preferred shares work?

Every Saturday, one of our journalists answers, along with experts, one of your questions on the economy, finances, markets, etc.

I’m having trouble understanding preferred stock. I have some in my portfolio (purchased by my former advisor). In the description there is a percentage yield and a period of 5 years. I don’t know if I should keep them until they mature or if I should sell them. Can you explain how it works and especially when to sell and under what circumstances? – Françoise Goes

Preferred shares are basically a financing tool used mainly in the country by large banks, insurers, certain public utility companies (BCE for example), the energy sector (TC Energy and Enbridge in particular) and large conglomerates such as Power Corporation and Brookfield.

Preferred stocks sell on the stock market like common stocks, but like bonds, they pay periodic income called dividends. To distinguish them, the letters “PR” are attached to the stock symbol of preferred shares.

For a patient investor looking for income and who understands that their investment is backed by an issuer with a strong credit rating, preferred stock can be an attractive asset class at current levels.

Each preferred stock issue is unique and has a prospectus in which the rules of the game are explained.

There are those commonly called “perpetuals”, which have no fixed maturity and which, as their name suggests, pay fixed dividends in perpetuity.

There are also those with adjusted rates where the dividend rate is determined at the time of the issue for a period of five years. The rate is reset every five years according to the 5-year Canadian interest rate in effect, plus a yield bonus stipulated in the contract.

Let’s take the example of a real case, that of a large financial institution which issued preferred shares in the summer of 2014. Every five years, it has the option to repurchase them. If she repurchases these shares, she must pay the par value which is the value at issue, that is to say $25.

If it decides not to exercise its $25 redemption right, the dividend is recalculated for a period of five years.

What creates an opportunity right now is the fact that the value of preferred shares has fallen significantly. That of our example has fallen to $17 since its issue at $25 more than nine years ago.

The rates on these preferred shares will have to be adjusted next summer. They were reset for the first time for five years in July 2019 when the rate on 5-year Canada bonds used as a reference was only 1.39%.

If 5-year rates in the country remain near their current level of approximately 4%, the dividend on these preferred shares will be significantly increased for the other five years to a rate approaching 9% at the current price of $17.

This is a more than interesting return for the quality of the issuer, underlines portfolio manager Daniel Ouellet, of the Ouellet-Bolduc Group, affiliated with Desjardins.

“Considering the par value of $25, the current price of $17 offers a patient investor able to think contrarianly, a very high, tax-efficient dividend income in addition to the potential for appreciation,” adds the one who sees an opportunity to be seized currently with certain preferred shares.