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 the $8.20 will be taxed as dividends and the $2.80 will be a capital loss (according to Royal Bank document Considerations for Preferred Share Investors).
Preferred shares are worth considering along with other fixed-income investments, but it pays to understand the fine print and tax consequences to make an informed decision.