Thursday, April 29, 2010

A Nearly Sure 6% Return?

In these days of low fixed-income returns, preferred shares of Canadian banks are offering impressively high rates. In some case the dividend yield is above 6% per year. What gives?

Let’s take Bank of Nova Scotia series 12 preferred shares (ticker: BNS.PR.J) as an example. As I write, these preferred shares are trading for $21.65 and pay a dividend of $1.52 per year (actually a half-cent more than this). This is a dividend yield of 6.08%.

According to the prospectus, Bank of Nova Scotia can redeem these shares any time after 2013 October 29 for $25 each. So, you either get to keep collecting your 6.08% each year or they take the shares off your hands for a capital gain of $3.35 per share. This sounds like heads I win and tails I win.

Lenders are still offering rates on 3-year closed mortgages below 4%. So, there is a spread of over 2% between what you could pay for a mortgage and what you could collect on these preferred shares.

There is always the possibility that Bank of Nova Scotia could default on its obligations, but how likely is that? This all seems too good to be true. What am I missing?


  1. The only question about buying these preferred shares is if they'll sell off more because of the market anticipating further rate increases.

    I know 2013 is a little down the road, but I'm not sure the bank will be buying the shares back. They've issued a lot of these types of products in the past 2 years.

  2. Well, looks like I'll be up all night reading prospecti...

  3. @Financial Uproar: This deal seems too good to be true even if the bank never redeems the shares.

    @Potato: Maybe there is something hiding in the prospectus that explains the low price of these shares.

  4. Yes, it looks safe. Of course, the common pays a 3.5% dividend, and has the prospect of a rising dividend as well. That would entail more risk for a possibly better return.

    6% for a fixed income proxy looks good though. Nice find.

  5. @Gene: I like the idea of owning the common shares as well, but for someone looking for fixed income, the preferred share look unusually good.

    @CC: CPD is a diversified version of the same thing. Assuming that its constituents have similar properties to BNS.PR.P, I'm not sure why CPD is paying 6.4%. Why doesn't this look attractive to investors leading to buying, increased prices, and a lower dividend yield?

    1. The second reply above is to Canadian Capitalist's comment:

      I don't follow Preferred shares but why not something like a diversified ETF such as CPD. Dividend yield is 6.4%.

  6. There's a lot left for me to learn about these. One big thing I'm trying to figure out is how likely the bank is to redeem them on the maturity date (and it's completely at the bank's discretion).

    I thought I read somewhere ~2 years ago that traditionally the bank redeems the perpetual preferreds, even when it's not necessarily in their best interest, as a matter of tradition. However, I can't seem to find any information on that, but neither can I find any issues in the tables of outstanding preferreds that have maturities in the past. That might just be because interest rates are low now, so all the past issues were more expensive, so it was in their interest to redeem and reissue now.

    If there's a good chance of this issue being redeemed at $25 in ~3 years, then the combination of dividends and capital gains in a reasonable timeframe is very attractive to me.

    If they are indeed going to remain "perpetual" then I'm not quite as sure about how lucrative 6.08% is for the very long-term; certainly not terrible though.

  7. Wondering how you are getting your numbers for CPD. I've got CPD with a yield of 0.84 per year which is 5.2%.

  8. Couple of points:
    Are they too good to be true? No, definitely not. They have advantages and disadvantages vs. common stocks and bonds.

    You have to assume they'll be redeemed by the bank if it's in their best interest to do so, and assume they won't be if it's in your best interest that they do.

    They pay dividends, so the income is tax advantaged vs. interest payments. Particularly important if you're paying tax at the top marginal rate.

    Pref shares are behind bonds in the capital structure, so in the event of default you're less likely to recoup your capital. The dividends are also at the banks discretion. They generally have to cut the dividend on their common stock to zero before they can cut the dividend on the pref, but in a bad case scenario the bank can suspend the dividend on the preferred shares, which they can't do on their bonds.

    For a vast amount of info on the Canadian pref share market, check out:

  9. @Potato: Perhaps you've hit on the reason for the apparent high return -- this return has to be attractive for the long term rather than just right now.

    @Robert: Matt suggests checking I have only taken a quick look myself.

    @Jason: You're right that CPD is currently paying only 5.2%. Perhaps CC's information was stale.

    @Matt: Thanks for the information. Even taking into account your points, a yield over 6% still seems attractive. Perhaps it won't seem so attractive after interest rates rise.

  10. If they are indeed going to remain "perpetual" then I'm not quite as sure about how lucrative 6.08% is for the very long-term; certainly not terrible though.

    This statement is EXACTLY why they are trading lower. Stock prices ( all prices on most things for that matter) are a function of sentiment of the buyers and sellers in teh market. If you go through a rising interest rate cycle there may be more to buy later at higher interest. But 6% from tax efficient source is a great way to stabilize your portfolio and collect income . Theres NO hidden risk . Hold them forever, or have the bank redeem at par...your still collecting 6%, and unlike commons the dividend is contractual!

  11. Hi Michael. A company is only required to pay preferred stock dividends as long as it is paying a dividend on its common stock. If they cancel the common stock dividend, the preferred stock's dividend can be chopped too. This leaves you holding a broken promise, no ownership in the company, no collateral, and no legal recourse. How much is that worth? Only as much as a greater fool is willing to pay.

  12. Based on the comments above it sounds like the bank has to pay a higher interest rate on these than on bonds, but I'm not sure how much (1-2% maybe?). They wouldn't want to redeem these shares if issuing new bonds is more expensive. This would likely mean that interest rates have risen significantly, lowering the value of these shares, or the bank is weaker, lowering the value of these shares. Either way you have a chance that you can't get out without a loss on your investment.

    That's similar to any bond, just with a higher yield because of the risks others have mentioned. The worst case for devaluation without actual interruption of the payments is that you might be left with a big enough loss that you're stuck collecting the interest for a very long time with no desirable liquidity.

    That doesn't mean these are a bad investment, just that there are reasons for the yield. I like long-term investing so the liquidity risks wouldn't stop me from considering these.

    There must be something from the corporate finance side that explains why companies issue preferred shares. I hear about them more often from banks - maybe the main attraction is that they're structured as stable long-term securities, as a counterweight to their deposits that could all be withdrawn overnight.

  13. They are discount Preferreds the bank is not paying 6%, the bank is paying what the coupon says, probably 4.5% because the bank got 25$ a share when the bank issued them. now they are trading at a discount, so the rate is higher if you buy now for less.

    yes preferred shares are a very important part of a dividend portfolio, I have a 35% target for preferred shares.

  14. The dividends are non-cumulative and payable "as and when" by the Board in its discretion. So, it seems far from a sure-thing that these will yield 6%. It would be helpful to know BNS's track record of declaring dividends on their prefs, or at least what the industry norm is.

  15. @Anonymous: I've never heard of one of the big Canadian banks failing to pay dividends on either common shares or preferreds. Perhaps someone who follows banks more closely can say when (if) it has happened.

  16. Michael:
    Any reason for focusing on BNS.PR.J? Was it perhaps one of the better values among the bank preferreds?

  17. @Larry: BNS.PR.J was one of the preferred I was looking at a few years ago when I was trying to learn more about preferreds. It looked interesting to me at the time. I don't know if it is better or worse than other preferred shares.

  18. Hi! I'm new to the investing field. But I've experience in stock trading. Now, I like to invest mutual fund Or bonds Low risk Investing. I don't know exactly how they work. I would like to learn about these. If you know any material to learn about that. books or videos
    advance thank you sir!

  19. @Sibi: The best idea is to spend some time learning before doing too much trading. Many people over-confidently start trading and lose money. You can try some searches on this blog to find useful material. There are also some other good blogs listed at the bottom right of this blog. Good luck.

  20. When you search for a company's preferred shares, there's usually a whole bunch of them (Class A, Series xx, etc.)
    What are the differences? Which one should we be buying if we are interested?

  21. @Anonymous: Preferred shares come with all kinds of different rules. It's best to look at the prospectus of the shares you're interested in. You can get the prospectuses at the company web sites. The most critical information is usually on the first page, although the rest of the document may have important details as well.

  22. Devil's advocate, consider the bet over the next 20 years, Wouldn't you rather invest in the bns stock and make 3.9% with the chance of stock appreciation and dividend increases? Say interest rates soar, there isn't a hope in hell BNS will be buying these things back in 2013.

  23. @Vanwash: Actually, I would prefer to own the common stock rather than preferred shares. This is because I have a 100% stock allocation. However, for the majority of people who have some fixed income, preferred shares look like an interesting alternative to bonds right now.

  24. Did you consider that the bank will take 15%for Canadian Tax right off the top and also they will not pay US dollars but the exchange rate of Canada and US

  25. @Anonymous: You're right that this is a better deal for Canadians than Americans. Withholding taxes and exchange costs can be significant.