Monday, December 7, 2009

Preferred Share Yield Fantasy

The dividend yield reported on preferred shares is often misleading. These reported figures don’t take into account potential gains or losses when these shares are redeemed. Unwary investors can get surprised if they chase high yield without reading the fine print.

Preferred shares are issued by companies to raise capital. Typically, they are sold for $25 each and promise fixed quarterly dividends until they are redeemed for $25 each. With common stock, shareholders own a slice of the company, but investors in preferred shares just get dividends. The name “preferred” comes from the fact that if the company has financial trouble, owners of preferred shares get paid before owners of common stock.

Just because a preferred share starts and ends its life at $25 doesn’t mean that it holds steady at $25. If market conditions make the fixed dividend payment more or less attractive, the share’s price will fluctuate up and down.

Usually preferred shares get a higher dividend (in percentage terms) than common stock gets. For example, as I write this, Royal Bank of Canada stock (ticker: RY) is paying a 3.58% dividend, but the series AR preferred shares (ticker: RY.PR.R) is listed as paying a 5.62% dividend.

For fixed-income investors looking for higher yield on their money, 5.62% probably looks pretty good. After all, Royal Bank isn’t likely to go out of business or struggle so badly that they can’t pay the preferred share dividends. But, it is dangerous to chase yield without checking the details.

Royal Bank’s series AR preferred share prospectus says that these shares initially paid a fixed 6.25% dividend. How could the payments be only 5.62% per year now if the dividend is supposed to be fixed? The answer is that the current share price is up to $27.80 instead of $25. The total dividend amount per year of $1.56 hasn’t changed, but it is now only 5.62% of the current share price.

The prospectus also says that Royal Bank can redeem these preferred shares on 2014 Feb. 24 for $25. But an investor buying now is paying $27.80. That’s a loss of $2.80 per share. The 21 quarterly payments left until the redemption date add up to $8.20. That leaves the investor a profit of only $5.40. Taking the present value of the share purchase, dividends, and $25 redemption, the yield works out to only 3.96%.

Another consideration for taxable accounts is that for most Canadians the $8.20 will be taxed as dividends and the $2.80 will be a capital loss.

Preferred shares are worth considering along with other fixed-income investments, but to make an informed decision, it pays to understand their risks along with the fine print and tax consequences.

4 comments:

  1. "Preferred shares are worth considering along with other fixed-income investments..."

    Benjamin Graham might disagree with you on that. :-)

    "Really good preferred stocks can and do exist, but they are good in spite of their investment form, which is an inherently bad one." -- The Intelligent Investor, chapter 4

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  2. Patrick: Graham's objection to preferred shares is that they carry the risk of default without sharing in the upside if the company performs well. This is a legitimate concern and must be factored into any comparison between preferred shares and bonds. It certainly doesn't make sense to invest all of your money into preferred shares of one of Canada's big banks, but some investors might consider the risk of default by the big banks to be low enough. After comparing after-tax returns of bond interest and preferred share dividends for the investor's particular tax situation, it is possible for the preferred shares to give enough extra return to compensate for the default risk.

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  3. "With common stock, shareholders own a slice of the company, but investors in preferred shares just get dividends. The name “preferred” comes from the fact that if the company has financial trouble, owners of preferred shares get paid before owners of common stock."

    In this case with the recession happening is it still wise to purchase dividend shares ?

    If a company is in trouble will there be any profit for anyone holding shares?

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  4. Katie Adam: Whether you choose to buy preferred shares depends on the rates offered compared to other fixed-income investments, your tax situation, and the risk of default. If a company gets into serious enough trouble, they will stop paying the preferred share dividends. If things get bad enough, they may default on the promised redemption as well. This is the risk that one takes with preferred shares. So, preferred shares have to offer a premium over the return that we can get from guaranteed investments like bank GICs.

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