Reconsidering preferred share allocations

Preferred shares represent an alternative source of capital for corporations, often described as a hybrid security that has features of both common stock (equity ownership, dividend payments) and bonds (higher claim to assets in the event of liquidation).

Preferred share exposures are typically considered fixed income assets by advisors, replacing traditional bond holdings in client accounts. 

Unlike bond coupon payments, preferred share dividends are not legal obligations and failure to pay will not lead an issuer into a default status. The dividend rate may be fixed or linked to a reference rate. Fixed-reset preferred shares, which make up most of the preferred share market, have their dividend rate reset every five years at a spread over the 5-year Government of Canada Bond.

Existing investment rationale

The most attractive feature of preferred shares is the higher post-tax yield compared to fixed income securities. Currently corporate and individual investors receive favourable tax treatment when owning preferred shares.

Catalyst for consideration

The 2023 federal budget proposed to tax financial institutions on dividends received from Canadian preferred shares, securities which were previously exempt from business income, potentially eliminating a significant after-tax benefit for some corporate owners. 

As a result, the institutionalization of the Canadian preferred market is likely to continue, as banks and other financial institutions issue new limited recourse capital notes (LRCN) to satisfy their funding needs as an alternative to the preferred share market. As the preferred share market shrinks, liquidity for the remaining outstanding preferred shares has deteriorated. Preferred share valuations have declined as markets search for alternative buyers under sustained selling pressure.

Source: BMO Capital Markets as of May 31, 2023

Recommendation

Prior to the proposed change in tax guidelines, financial institutions that owned preferred shares benefitted from the favourable tax treatment of preferred dividends. However, with the new budget proposal, these corporate owners are left holding an asset that offers similar after-tax returns to corporate bonds with significantly higher volatility and risk. 

Under these circumstances, corporate investors have begun to rotate out of preferred shares into other asset classes, creating sustained selling pressure and underperformance for preferred shares relative to substitute fixed income assets. This is a structural change to a large portion of the preferred share market buyer base, and we don’t see an obvious replacement buyer that could step in and cover the supply overhang. 

For clients and advisors, crystallizing losses has become common practice recently. Legacy fixed reset preferred shares without a floor don’t have a clear path back to par. There is no clear catalyst that can drive the recovery in preferred share prices. Given this background, and as central banks near an end to the rate hike cycle, we believe now is a good opportunity to reduce preferred share holdings in favour of corporate bond exposures.

Source: Morningstar as of 3^1st May 2023

To learn more about Mackenzie Investments fixed income solutions visit mackenzieinvestments.com.

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