This is the second video in a multi-part series
about alternative investments.
In the first video in this series, I told
you why high-yield bonds fall short on a risk
adjusted basis, and should only be included
in your portfolio in small amounts through
a well-diversified low-cost ETF, if at all.
If you haven’t watched it yet, click here.
And BTW, I do not recommend high yield bonds
in the portfolios that I oversee.
Alternative investments are generally sold
on the basis of exclusivity to wealthy individuals.
Warren Buffett said it best in his 2016 letter
to shareholders: “Human behavior won’t
change.
Wealthy individuals, pension funds, endowments
and the like will continue to feel they deserve
something “extra” in investment advice.”
In addition to high yield bonds, income-seeking
investors may turn to preferred shares.
Preferred shares typically offer higher yields
than bonds.
They also have some tax benefits for Canadians
who own Canadian preferred shares.
While these benefits are attractive, preferred
shares also come with additional risks and
complexity that bonds do not have.
Remember, risk and return are always related.
I’m Ben Felix, Associate Portfolio Manager
at PWL Capital.
In this episode of common sense investing
I will tell you why I prefer to avoid preferred
shares.
Preferred shares are equity investments in
the sense that they stand behind bond holders
in the event of bankruptcy.
In a bankruptcy, debt holders would be paid
first, followed by preferred shareholders,
and then finally common stockholders.
Typically, preferred and common shareholders
will receive nothing in a bankruptcy.
Where preferred stocks differ from common
stocks is that they do not participate in
the growth in value of the company.
The return on preferred stocks is mostly based
on their fixed dividend.
Unlike a bond, preferred shares do not generally
have a maturity date.
This makes them effectively like really long-term
bonds.
Unfortunately, fixed income with long maturities
tends to have poor risk-adjusted returns.
Long-term fixed income also exposes you to
a significant amount of credit risk.
Can the issuing company pay you a dividend
for the next 50 plus years?
Like a bond, if interest rates fall, the price
of perpetual preferred shares can increase.
While this sounds good, the problem is that
perpetual preferred shares typically have
a call feature.
If interest rates fall too much, the issuer
will redeem the preferred shares at their
issue price.
The same thing can happen of the credit rating
of the issuing company improves, allowing
it to issue new preferred share or bonds at
a lower interest rate.
This creates asymmetric risk for the investor.
They get the risks of an extremely long-term
bond, but have their upside capped.
One of the most common types of preferred
shares in the Canadian market are fixed reset
preferred shares.
These have a fixed dividend for 5-years, which
is then reset based on the 5-year government
of Canada bond yield plus a spread.
Investors are able to accept the new fixed
rate, or convert to the floating rate.
This process continues every 5-years and helps to reduce interest rare risk.
In 2015, rate reset preferred shares dropped
in value significantly, causing the S&P/TSX
Preferred Shares index to fall 20% between
January and September 2015.
Preferred shares have some other characteristics
that make them risky.
A company is usually issuing preferred shares
because they want to raise capital but are
not able to issue more bonds.
This could be because they can’t pile any
more debt onto their balance sheet without
getting a credit downgrade.
Companies also have a much easier time suspending
dividend payments on preferred shares, which
they can do at their discretion, than they
do halting bond payments, which would mean
bankruptcy.
These characteristics might cause an investor
looking for a safe asset to think twice.
Enough negativity.
Why does anyone invest in preferred shares?
I’ve already mentioned the higher yields
that preferred shares offer compared to corporate
bonds, making them attractive to an income-oriented
investor.
Canadian preferred shares also pay dividends
that are taxed as eligible dividends in the
hands of Canadian investors.
This might make preferred shares a good candidate
for the taxable account of an investor that
pays tax at a high rate.
Preferred shares do also have returns that
are imperfectly correlated with other asset
classes, meaning that there can be a diversification
benefit to including them in portfolios.
So, should you invest in preferred shares?
For their few benefits, preferred shares have
substantial risks.
In Larry Swedroe’s book The Only Guide to
Alternative Investments You’ll Ever Need,
he writes that “The risks incurred when
investing in preferred stocks make them inappropriate
investments for individual investors.”
I do not recommend preferred shares in the
portfolios that I oversee.
In a 2015 white paper my PWL colleagues Dan
Bortolotti and Raymond Kerzerho recommend
that if you are going to invest in preferred
shares, you should only use them in taxable
accounts, limit them to between five and fifteen
percent of your portfolio, and diversify broadly.
They also emphasize that you should avoid
purchasing individual preferred shares due
to the complexity of each individual issue.
Join me in my next video where I will take
a break from this mini-series on alternative
investments to tell you why income investing
doesn’t really increase your income.
My name is Ben Felix of PWL Capital and this
is Common Sense Investing.
I’ll be talking about a lot more common
sense investing topics in this series, so
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I want these videos to help you to make smarter
investment decisions, so feel free to send
me any topics that you would like me to cover.
