With investors flocking to “income” products it is worth
taking a moment to understand the risks that can be associated with innocuous
sounding investments in the “income” generating asset pool. The current
Canadian regulatory standards apply virtually no meaningful assistance in
assessing product risk. As such, many investors fall into the trap of believing
an “income” security is similar to the risk profile of “fixed income”
securities that provide on-going income. This is not a surprise given that
investment advisors/salespeople generally speak of “income” products as a
replacement for “fixed income” securities such as investment grade bonds. Given
the growth in the number of “income” products, now is a great time to lift the
hood on preferred shares; one of the basic income securities growing in
popularity.
Preferred
Shares (or prefs) is a hybrid product which has features of both equities
(common shares) and fixed income (bonds). There are several types of preferred
shares and the various types can have very different risk profiles. As a
general rule the type of preferred share issued will vary based upon a
combination of what the issuing company requires and what terms investors will
accept at the time of issue.
Preferred Dividend
Position: The primary benefit of a preferred share is first call on
dividends at a pre-set rate. The pref share dividend is more secure than the
common share dividend and may have assets backing the shares in the event of
corporate default. A 3.5% pref share will be paid 3.5% of the face price annually,
at the discretion of the board of the issuing company. Should the company not
have sufficient cash to pay all dividends, the pref shares have first right to any
dividends paid before the common shareholders receive any dividend declared. As
always the dividends are paid at the direction of the company’s board of
directors. When you hear about a company cutting its dividend that is almost
always the “common share” dividend being reduced and only very rarely would it
include the “preferred share” dividend.
Features of Pref
Shares:Pref shares are issued by “charter”. The charter is similar
to the trust deed of a bond issue in that it describes the rights of the pref
share holder as a debtor of the company. It is the preferential access to
dividends stated in the charter that give these shares their name. In return
for this preference the holders of pref shares give up any right to vote as a
shareholder of the company. In general the common share holders are entitled to
a vote for each share owned (I am ignoring the few companies that have
non-voting common share classes as they are the exception not the rule.). The
lack of voting rights does not tend to hamper the average retail investor
although it may discourage some large institutional investors.
Market Value of a Preferred Share:
The preference shares will be sold with a face value such as $25.00 per share
and it is this value that the dividend is based upon. For example a 4% pref
share issued at $25.00 would pay a fixed annual dividend of $1.00 at the
company’s discretion. The pref shares have no claim to any growth in profits
and as such they trade at a value that is based primarily upon the dividend
guarantee. In this sense the pref share value behaves very much like a bond or
debt instrument. The value of the stream of dividends is comparable to the
interest yield on a corporate bond. As such, an increase in the market yields
of either bonds or new pref shares will cause pref shares to drop in value. A
decrease in yields will similarly cause pref shares to rise in value.
Cumulative or
Non-cumulative Dividends: Pref shares can have dividends suspended should a
company need to do so. However, a “cumulative” pref shareholder must receive
all missed dividend payments before any common share dividend can be paid by
the company and before any pref share is redeemed by the company. A
non-cumulative pref share has no right to recover missed dividend payments when
regular dividends are re-started by a company.
Restricted Terms:
A preferred share charter may restrict the company from issuing any future pref
share series with a senior debt position to the specified preferred share
issue. In some situations the restrictions may prevent a company from selling
specified assets prior to redeeming the preferred shares referred to in the charter.
Risk Profile: Preferred
shares are exposed to a unique set of risks that many retail investors are not
aware of. The hybrid nature of the shares provides both additional security and
additional risk characteristics. The risks of each pref share series must be
determined separately prior to making a purchase.
Debt Risk: An
example may be the best way to showcase the unique issues around evaluating pref
shares within a company:
Company ABC currently has several series of preferred shares
outstanding as follows:
-
One “preference share series A, 4%” and 3 series
of preferred shares B.C, and D at 5%.
-
The holders of the “preference” shares are
holding a preferred share similar to B, C, and D series holders. The difference
is that the “preference” series has a higher ranking of security should the
firm default on their obligations.
-
The B, C, and D series are legally defined as
“pari passu”, which means they all have equal rights to the firm’s assets.
These rights however are subordinate to the series A shares.
-
Should the company go into receivership the
series A pref shares will recover their capital before the series B, C or D
even though all are “preferred shares”.
The above example is intended to show that a preferred share
is a subordinated debt instrument. When determining the risk profile of a pref
share it is important to understand the security backing the share series and
how it ranks relative to both corporate bonds, loans, and other outstanding
pref series of the company. That also means it is important to understand the debt
risk profile of the issuing company. The failure to understand this debtor risk
is proving to be a significant issue for many investors who hold bank pref
shares. More on this later!
Price Risk:
Preferred shares tend to trade off the dividend yield as mentioned earlier. The
price risk is often misunderstood as it is much more difficult to measure and
understand. Again, let’s use a hypothetical example to clarify the issue:
An investor has his eye on two high flying firms that have
great free cash flow and solid balance sheets. Not wanting to risk investing
directly in the equity markets he decides to invest $10,000 in pref shares of
each firm, Sino China and Banana. Subsequent to the purchases each company has
a very different experience. Banana launches a new computer tablet and shares
soar to massive heights with common share prices tripling in value. Sino China,
in contrast, is subject to fraud charges and the company goes into
receivership.
So how did our investor do when the share prices fluctuated?
Taking the positive first; the pref shares of Banana are still worth $10,000
and dividends are very secure. As a pref shareholder however, our investor
receives no direct benefit from the remarkable success of Banana and the increase
in common share price. As for Sino China, the company is taken into
receivership and eventually taken over by the creditors. There are insufficient
assets to pay all debtors and as such banks are paid, bond holders lose much of
their investments and the pref shares are priced to $0.00. Our investor gets no
dividends and no return of capital from Sino China.
Had our investor bought common shares he would have still
lost $10k on Sino China but also would have made $20,000 profit on Banana
shares. He would be ahead by a net $10,000.00. Instead he avoided the risk of
the equity markets and miscalculated the risk in the pref share market to his
determent. As an aside, this example works equally well if you substitute
Nortel or Lehman Brothers for Sino China in our hypothetical scenario. The
bottom line is that investors need to determine the relative risk of holding
pref shares instead of common shares or bonds. The investor needs to consider
both an upward and downward scenario for share prices before deciding to buy
pref shares.
Interest Rate Risk:
Preferred Shares are similar to bonds in that the value of the preferred shares
can be greatly impacted by interest rate changes. As you would expect, a pref
share paying 6%, all things being equal, would have a greater value than a pref
share paying 4% dividend. Unlike bonds, the income payment on a pref share is not
generally set for a fixed period. Pref shares are generally issued for a set
amount such as $25.00/share and the owner would expect to receive $25.00 on redemption.
As discussed earlier, however, pref shares are issued based upon what the
market will accept. Given that the big brokerages make more money from issuing
companies than from investors in a pref issue; some of the common terms have
greatly increased the risk to the investor and lowered the risk to the
corporate issuer. This is the only way I can think of to explain “perpetual
preferred shares”. These shares are issued with no maturity date or reset
date and are redeemed at the option of the issuing company. In effect the
issuing company will leave these pref shares outstanding only if the dividend
is below the current market rates. This means these shares will trade either at
or below the expected debt market yield available to the company. As an
example, if the perpetual pref share pays 4% yield then the company will not
redeem the shares unless they feel they can issue new shares at less than 4%.
If the market rates should rise significantly then the value of the 4%
perpetual would be expected to plunge. With no way for investors to improve
yield and no way to redeem the shares, the investor must watch the value
continue to erode or the share must be sold at a loss based upon the current market
price of the share. Interest rate sensitivity of securities is based upon duration
which generally means the longer the time until maturity the higher the
sensitivity of the security value to interest rate changes. The duration would theoretically
be at its absolute highest when there is no maturity date. In contrast, when
market yields drop below the 4% the issuing company can call the shares for a
forced redemption thus lowering the companies borrowing costs. In short you
lose out if market yields rise and you are bought out if yields drop.
Why preferred Shares? The issuing companies generally pay
more to raise money via a preferred share issue than from a bond issue. The
reasons they would choose to do so reflect the current needs of the company and
of the market place.
For example:
-
If the
company has poor credit ratings it may not wish to go to the debt market
directly and thus will pay a premium in the pref market to raise money.
-
If the company is concerned it may need to miss
interest/dividend payments in the future it is easier to miss a dividend
payment than a mandatory bond or loan payment
-
If the company finds it cannot sell common
shares due to a poor market it may issue pref shares instead. The company may provide
an option to convert the pref shares to common shares at a set date at either
the company or investor’s option.
Benefits to the Investor: Pref shares do have some benefits
that can make the shares attractive to investors.
- Greater security than the common shares
- Greater security than the common shares
-
Dividend income can have favourable tax
treatment versus the interest income earned on bonds
-
Dividend rates may be higher than the bond rates
available in the current market
-
Pref shares may have conversion rights imbedded
in the share terms
Convertible Preferreds: Some pref shares come with an option
to convert the pref share to common stock based upon a pre-set formula. Typically
these offerings have a set period of time when the holder can elect to make the
conversion (retractable prefs) such as quarterly after the 5th year
and until the 10th year after the issue date. As a hypothetical example;
the pref share may trade at $25.00 and be convertible to common shares based
upon the $25.00 pref face value plus all dividends earned divided by the 20 day
average market price prior to the conversion dates. Convertible pref shares
would be expected to be issued at a premium to perpetual pref shares due to the
implied value of the conversion option. Occasionally the company will have an
option to force the conversion after a set period of time regardless of the investor
wishes. There is also a risk of declining market price for the pref if the
convertibility option loses value (i.e. shares drop significantly in price).
Variable Preferred Shares: Our preference in preferred share
options would be variable preferred shares. These pref shares have a reset date
at which dividends are adjusted to reflect market rates. In these situations
the risk of holding a perpetually “under market” dividend rate is mitigated. As
an example, the dividend payout may be reset every five years at bank prime
plus 4%. This allows the rate to adjust up or down but assures the yield
remains somewhat consistent with the current benchmark market rates.
Flat Tail Risk:
Pref shares are susceptible to significant losses when markets or companies are
in turmoil. The lack of understanding of event based risks are leaving many
investors with significant risk that they are not qualified to understand or
evaluate. A perfect example is now playing out in Europe with respect to pref
shares of large Spanish banks. The banks are experiencing significant losses as
sovereign bonds they hold are being reduced in value. This in turn has left a
number of banks nearly insolvent and turning to governments to be nationalized
rather than facing bankruptcy. As the banks negotiate terms with creditors the
pref share investors are left holding the bag. The bond holders can negotiate
from some strength as they hold hard asset security in most cases. Many of the
pref shares hold only a claim against general revenues. As these banks work out
terms with creditors the pref share holders will likely be decimated.
Now we ask some
relevant questions: Did the retail pref share holder know that she was exposed
to a significant loss based upon the bonds of sovereign nations being reduced
in value? Did the retail pref share holder know that central banks encouraged
large banks to hold sovereign debt in their capital reserves even though these
bonds were of questionable value when issued, thus putting pref shares at significantly
higher levels of risk? Did the average advisor/salesperson understand the risk
of holding bank pref shares in a financial crisis?
Preferred shares do have a place in the security markets.
They are not however your plain vanilla investments. They are not an equal risk
substitute for investment grade bonds. Hybrid, complex financial instruments
should not be sold to unsophisticated investors and should not be sold by your
basic stock salespeople. I suspect that a number of income hungry seniors will
be burnt by poor advice and basic overconfidence. After the fact many will
complain they should never have been sold these securities....and they will be
right.... and they will suffer significant losses that will not be recoverable.
The most likely causes of a large loss will be dysfunctional credit markets,
spiking corporate cost of borrowing, and lack of foresight to get out of the
security before the prices collapse. Only sophisticated investors with support from
top quality independent analysts should invest in complex securities.
p.s. Your mutual fund salesperson is not independent and is
not likely an analyst.