Preferreds generate tax-efficient income

There’s a running gag line in the fixed-income world that “Gentlemen prefer bonds,” which is a jab at the preferred share market. But with the seemingly eternal quest for higher yield, preferreds now get more respect.

Preferreds are a hybrid investment; part equity, part debt. They rank behind bonds in the corporate credit spectrum but are senior to common stock, hence the descriptor “preferred.”

Like bonds, credit-rating agencies assign them ratings. Like stocks, preferred shares trade on stock exchanges. There are even ETFs and mutual funds that hold only preferred shares.

There are subtle nuances and terms associated with preferreds. As an example, they may be convertible to common shares. Others may participate in sharing in a corporation’s profits, but most don’t have voting rights.

Preferreds offer an advantage over bonds in that their dividends receive more favourable tax treatment from the Canada Revenue Agency than does interest income. Why? Any dividends are paid from corporate after-tax profits. Because a company has already paid taxes on what it’s earned, it’s hardly fair to double-tax the money once it hits investor pockets. The CRA knows this and tries to adjust. It “grosses up” the amount of the dividend: 38% for eligible Canadian companies in 2012 and after. In theory this grossed-up number reflects a firm’s pre-tax profits. The CRA calculates federal and provincial taxes based on this grossed-up number. Here’s the twist; it then gives credit to the investor for taxes the firm has already paid. That credit is 15.02% of the grossed-up number.

Each calculation varies with individual marginal tax rates and provinces. The top tax bracket in Ontario (over $509,000) is 49.53% in 2013; interest on bonds is taxed at that rate while eligible dividend income is taxed at just 33.85%. Bottom line is dividends get better tax treatment than interest and the advantage is greater still in lower tax brackets.

In 2008, a new preferred came on the scene. Canadian banks needed Tier 1 capital to shore up finances in the financial crisis. Interest rates were falling quickly, so to attract funding banks issued so-called ‘reset’ preferred shares. These pay fixed dividends until a reset date, typically five years from issue date. Two things can then happen: the preferreds are redeemed or the dividend rate is ‘reset.’ The reset rate is a function of a preset “spread”: extra yield. At each reset date, investors can opt for a series based on the yield of five-year Canada bonds plus the spread, or a “floating rate” series that pays the quarterly dividend based on three-month Canada Treasury bills plus the spread.

Sound complicated? As an example, TD Bank issued 5% Series S AA preferreds (TD.PR.A) in 2008, so holders collect a 5% dividend until the reset date of Jan. 31, 2014. TD can redeem these at $25 or leave the series outstanding. The spread for the reset is 1.96%. If yields are 1.75% for the five-year Canada bond, TD can set the new fixed-dividend rate at 3.71% (1.75% + 1.96%). Investors get paid 3.71% for the next five years or can convert to the floating-rate dividend option. That pays three-month T-bills plus 1.96%, varying quarterly. Either the preferred is “called away” or you choose the kind of dividend you’d like: fixed or floating.

Put yourself in the bank’s shoes. Would you rather finance operations at a pre-determined spread to government-issued interest rates or not? It depends on market conditions. Perhaps the bank can go to market and get cheaper financing. Or not, but extending the preferred avoids costly fees for new underwritings.

The bank’s flexibility represents a risk to investors. If the preferred is called away, the $25 value is returned but now they must find a fresh investment for the proceeds. The key to assessing the risk is the “spread” or difference between the government interest rate and the one they must pay. If the spread is too high, the bank redeems the preferred. If too low, or the reset date is too far off, investors may avoid such investments in future and the bank will need to find new funding.

With interest rates near historic lows, they can only go up. At some point, hopefully not too soon, yields on Canadian bonds will rise. That’s why I like this type of preferred. Reset preferreds let investors capture that change in yields and get a little extra return besides. Knowing the yield can adapt to rising interest rates should be of comfort to most fixed-income investors.

Preferred investing is trickier than common-stock or bond investing but offers attractive yields and favourable tax treatment. “Reset” preferreds also offer the extra benefit of adjusting to rising rates. Even so, they may not be everyone’s cup of tea. Curiously, in the early 20th century, the expression “a cup of tea” was synonymous with acceptability—of being a gentleman!

Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitter feed is @patbolland.