Are preferred shares a good buy?

Talk to any income investor for long enough and eventually preferred stocks will come up. They can provide a regular income, but they can be tough to understand. After all, preferred stocks are the chameleons of the investing world: Sometimes they look like a stock, sometimes they look like a bond.

Once your portfolio hits a certain size, this chameleon-like behaviour can come in handy, but before you buy, you need to understand how they work. Here’s four things you need to know:

First, most kinds of preferred share dividends are fixed at a set rate when they’re issued. That makes their income similar to the interest you get on bonds. That’s why reliable preferred share dividends paid by solid companies are considered fixed income.

Second, preferred share dividends are more reliable than the dividends paid on a company’s common shares—but less reliable than the interest paid on its bonds. If a company runs into financial difficulties, it first cuts common share dividends, then it cuts preferred share dividends. It will stop paying interest on its bonds only if it’s on the verge of bankruptcy.

Third, before taxes, the yields on preferred shares tend to be pretty similar to those of long-term bonds for the same company, says preferred shares expert James Hymas, president of Hymas Investment Management in Toronto. Even though they’re not as reliable as the company’s bonds, they give you about the same before-tax yield. So if you’re investing inside a TFSA or RRSP where taxes don’t matter, go with the bonds.

Fourth—and this is their key advantage—the dividends on Canadian preferred shares get the same highly advantageous tax treatment as dividends on Canadian common shares. So they generally beat bonds hands-down when held in non-registered accounts, where taxes matter. In fact, as a rule of thumb, a bond has to generate about 1.3 times the before-tax yield in order to end up with the same after-tax income compared to a preferred share, says Hymas.

Be careful though—there are some risks associated with preferred shares as well. Unlike corporate bonds, traditional “perpetual” preferred shares have no maturity date. That’s great if you want to lock in a set dividend for a long period. But it also makes the dividends very sensitive to interest rate changes. You can expect the value of the shares to fall quickly if rates rise.

Finally, you’re never assured of getting your capital back intact. With a bond, you know you’ll receive the face value of the bond upon its maturity (unless the company is in exceptional distress). For a “perpetual” preferred share, the only way you can get your principal back is to sell your shares on the market—and you might get less than you paid. On the other hand, if your shares go up in value, you might not get the benefit. In most cases the issuing company can “call” or buy back the shares at a set price after a period of time if the price gets too juicy in relation to the share’s face value.