Preferred options to help in rocky times

Common stock's first cousin, preferred shares are an easy way to boost and secure yields, Andrew Allentuck writes

By Andrew Allentuck
Globe Investor Magazine online,
December 30, 2008

For anyone dependent on a pension or getting close to retirement, safety of cash flow from investments is at least as important as increasing it. Of course, it's possible to buy common stock in the present bear market and hope for some capital gains down the road, but it can take immense fortitude to stay with a stock or a mutual fund (and its annual fees) if the stock market continues to tumble. Having a stream of fairly secure dividends makes it easier to wait out the storm.

An easy way to boost and secure yields is to use common stock's first cousin, preferred shares. Preferreds specify their payouts as a part of the description of the stock.

The dividend is given with the title of the stock. For example, the CIBC class A Series 29, non-cumulative 5.4 per cent tells you that it pays 5.4 per cent of its initial price of $25, or $1.35 a year. That's 8.4 per cent of its recent price of $16.45.

Preferreds rank above common stocks when it comes to getting paid dividends. If a company does have dividends on common stock, those dividends cannot be paid until all dividends on preferreds have been paid.

In the event of bankruptcy, preferred shareholders have to be paid before the common shareholders get a cent. Bondholders rank ahead of preferred share owners in any payout of funds from a bankrupt company, but for a company that looks like it has enough operating income to pay all common and preferred dividends, the preferreds are a way to get more income with acceptable risk.

There is a caveat here, however. Preferreds, like bonds, have a fixed upside.

They cannot pay more than a stipulated redemption price, which is usually the issue price. Some preferreds that can be called by their issuers for redemption add a small premium to the basic redemption price as the $25 CIBC Class A Series 29s do - it's $1 beginning in 2010 and falls by 25 cents each year to 2014. There is an exception to the limited upside rule - rare convertible preferred issues such as Western Financial Group Inc.'s issues, which have recently been priced to yield as much as 63.5 per cent to conversion, have no price cap. The issues are not rated by any agency and the yield at this level should serve as a warning to be extra careful before plunging. The market for preferreds has tumbled along with the market for common stocks.

Companies with excellent credit ratings have seen their preferreds drop drastically, even though they are set to be redeemed in cash in just a year or two. But a special class of preferreds that take a pool of stock and give all the dividends to one class and all the capital gains or losses to the other class doubles the income for any level of investment for the dividend class shareholders.

For example, the Premium Income Fund, which is listed on the Toronto Stock Exchange with the symbol PIC.PR.A, has recently traded at $11.40 with a current yield of 7.65 per cent. It is due to be redeemed by the issuer at $15 on Nov. 1, 2010. If you hold it until then, its yield to maturity will be 22.31 per cent. The shares have a p-3 high rating from DBRS Ltd., which is below the middle in the full range of p-1 (best) to p-5 (worst). Yet as John Nagel, vice-president at Desjardins Securities Inc. in Toronto in charge of preferred trading, says: "I am comfortable with it."

An investor can also use a high income exchange-traded fund such as the Claymore Canadian Monthly Income ETF. This fund trades on the Toronto Stock Exchange just like any stock. Its symbol is FIE. Established in 2005, it lost 36.2 per cent of its net asset value for the 12 months ended Nov. 30. It has a 1.65-per-cent management expense ratio, which is high for an ETF. But it has a 66-cent annual distribution, equal to a yield of 13 per cent a year at its recent closing price of $5.26. Despite recent losses, it should show price appreciation when its underlying assets, including shares in financial institutions, regain value in the present bear market. Note that most of the payout of this fund is dividend income, which has a reduced tax rate if received outside of a registered plan. Other dividend-yielding ETFs include the Claymore S&P/TSX Canadian Preferred Index Fund, which trades as CPD on the TSX, with a 0.45-per-cent management expense ratio.

For investors with U.S. dollars, it's possible to buy similarly structured preferreds, though they are called fixed rate preferreds in the United States. There is only a handful of such issues, notes Cecilia Gondor, executive vice-president of closed-end fund specialty research and management firm Thomas J. Herzfeld Advisors Inc. in Miami.

She suggests that an investor might look at the Gabelli Global Multimedia Trust, Series B, which trades on the New York Stock Exchange with the symbol GGT. These preferred shares, rated triple-A by Moody's Investor Services, have recently been priced at $20.20, a 19.2-per-cent discount to their prospective price of $25 at call. The shares currently have a running yield of 7.4 per cent.

U.S.-source preferred dividends do not qualify for the dividend tax credit and therefore tend to be of less use to Canadian investors with taxable accounts. However, there are U.S. dollar preferred issues by several Canadian corporations, including banks, with high ratings and attractive payouts.

Finding yield substitutes for common stocks is a challenge. Preferred investors have to give up something in the form of security less than that of bonds or accept that shares other than perpetuals, which may never be redeemed, will tend to have an upper price limit at redemption. Like a suit of clothes, one size does not fit all.

- Special to The Globe and Mail