Preferred Shares

For Taxable

Fixed-Income Portfolios

Ontario Marginal Tax Rates

InterestWidows & Orphans

21.05%

Professionals

39.41%

Plutocrats

46.41%

DividendsWidows & Orphans

0.00%

Professionals

13.81%

Plutocrats

23.96%

Dividend / Interest Equivalency FactorHow much interest gives the same after-tax income as $1 Dividend?

Figures for Ontario• Widows & Orphans: $1.27• Professionals: $1.42• Plutocrats: $1.42Figures do not account for clawback of Old Age benefits

Dividends of 5% are as good as Interest of 7%, after tax effects

Types of Investment

• Common Stock– Represents ownership interest in company– Pays dividends– Chance for Capital Gains or Losses– Takes first loss in the event of difficulty– Subject to dilution when new common issued

Types of Investment

• Bonds– Fixed rate & Schedule of income– Holders can put company into bankruptcy– Little or no chance for Capital Gain / Loss

(from issue price)– Asymmetric risk / reward – No dilution of claims (quality may suffer)– Have First-Loss Protection

Types of Investment

• Preferred Shares– Fixed rate & Schedule of income– Holders CAN’T put company into bankruptcy– Little or no chance for Capital Gain / Loss

(from issue price)– Asymmetric risk / reward– No dilution of claims (quality may suffer)– Income is received as dividends– Have First-Loss Protection

Preferreds vs. BondsTrade-off

• Bankruptcy provisions– Income suspension– Seniority in bankruptcy

• Liquidity– Fewer big players in preferred share market– Volatility of market price

• Income– Therefore, after tax income must be higher

Perpetuals & Long Corporates

-0.02

-0.01

0

0.01

0.02

0.03

0.04

0.05

12/31/1997 12/31/1999 12/30/2001 12/30/2003 12/29/2005 12/29/2007

Date

Spr

ead

Types of Preferreds

• Floating Rate [All these are Perpetual]– Ratchet– Fixed-Floater– Floater– Fixed Reset

• Retractible– Operating Retractible– SplitShare

• Perpetual– Premium– Discount

Very different risks & rewards

Floating Rate Preferreds

• Class includes any issue that resets its dividend on a schedule.

• Usually bought with a view to inflation protection– Common stock in resources is better hedge

• Credit risk is perpetual

• Homogeneous market implies cliff risk

• Can be attractive when unpopular

Operating Retractibles

• Most bond-like of all preferreds

• Often priced to provide after-tax yield equal to bonds, despite increased credit risk

• However, lack of pension money may often lead to volatility and opportunities

Split-Shares

• Bond-like– Set Maturity Date (sometimes callable)– Income and Principal covered by investment

portfolio

• Asset Coverage Ratio important measure– Restrictions on payments to Capital Units?– Retractions?– Nature of underlying portfolio

Perpetuals

• Fixed income payments, no maturity date– Floaters are also perpetual!

• Redeemable by issurer, no retractions– Calls are bad!

• Highest return, highest risk

• Credit quality extremely important

A Preferred Share Portfolio

• No more than 50% of fixed-income total– Offset risks of preferreds with bonds

• Fewer Financials• Shorter Term

• Less diversification requires higher quality• Diversification available via ETFs

– DPS.UN– CPD

• Active management available via funds

Resources

• Credit Quality– www.dbrs.com– www.standardandpoors.com

• Issue characteristics www.prefinfo.com

• Daily commentary www.prefblog.com

• Newsletter www.prefletter.com