Preferred Shares: The Investment That Looks like a Stock and Acts like A bond
Chapter 15 of The Rational Investor
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Chapter 15: Preferred Shares; The Investment That Looks like a Stock and Acts like A bond
At some point in your investing journey, you will be pitched on investing in so-called “alternative” assets. They are referred to as alternatives because they are pitched as an alternative to the traditional portfolio of stocks and bonds.
A popular alternative asset often pitched to income hungry investors during times of low-interest rates and yields is preferred shares which are a hybrid asset that falls somewhere between a stock and a bond.
Let’s explore some of the basic features of preferred shares, how they are similar and different from stocks and bonds, and highlight some of the risks involved.
What are preferred shares?
Preferred shares are a hybrid investment that shares features of bonds and some features of common stocks (common stocks being the type of stock held by a rational index investor.)
If you take one thing away from this chapter, let it be this: Preferred shares are a complex investment.
Not all preferred shares are created equal; there different types of preferred shares that each have specific characteristics that can dramatically impact investors. Great care and research should be taken before considering preferred shares in your portfolio.
Since they are thought of as a hybrid asset that has features that resemble both stocks and bonds, it makes sense to compare preferred shares to each of the traditional asset classes to assess whether they have a place in your portfolio.
Preferred shares vs. bonds
Both preferred shares and bonds are sought after by investors looking for income as both assets pay regular income and can be sensitive to changes in interest rates.
Pros of preferred shares over bonds
Higher yields
The first thing that many income-seeking investors tend to look at is yield. The higher the yield, the more income you receive relative to your initial investment.
For example, a bond might have a yield of 2%, meaning you would expect $2 in income for every $100 you invest. A preferred share might have a yield of 5%, which means you receive $5 in income for every $100 you invest.
Tax efficiency
Preferred shares are a form of equity that means they pay dividends. Dividends receive a preferential tax treatment compared to interest income, which is what bonds pay.
In a 2015 paper, PWL Capital, a Canadian portfolio manager, looked at the tax savings of receiving $1,000 in income from preferred shares vs. bonds1. An investor living in the high-tax province of Ontario in Canada (where I live), making $50,000 per year, would save $227 in taxes on $1,000 paid by preferred shares compared to $1,000 paid by bonds.
(This is a Canadian example of investments held in a taxable account. The numbers will be different in other countries.)
That is a significant amount of savings and a powerful advantage of preferred shares over bonds.
Cons of preferred shares over bonds
Complexity
If you think investing in bonds is complex, the world of preferred shares can feel overwhelming.
Most bonds share a common set of characteristics, which is not always the case with preferred shares. To illustrate this point, in the U.S there are several different types of preferred shares:
Callable shares: allow the issuing company to buy back the shares at a fixed price in the future.
Convertible shares: can be converted into common shares at a fixed rate of preferred to common shares. For example, an investor may be able to convert one preferred share into two common shares of the issuing company.
Cumulative preferred shares: require that any unpaid dividends be paid to preferred shareholders before common shareholders.
Participatory preference shares: pay additional dividends when the issuing company hits financial or earnings milestones.