While preferred shares have historically been the domain of individual investors, they hold some attraction for institutional players seeking the regular income offered by bonds as well as higher returns.
“That’s the theory,” says Todd Nelson, Toronto investment leader at Willis Towers Watson, of the argument for preferred shares. “You’re further down in the security structure than bonds but you’re getting a higher return because of that.”
Among the attractions for institutional investors are the prices for preferred shares, says Colin Ripsman, vice-president and portfolio manager for institutional client services at Foyston Gordon & Payne Inc. “Preferred shares are really standing out to Canadian pension funds,” says Ripsman, citing the current environment of low prices for preferred shares.
For Nelson, the reason for the interest is twofold: supply and demand. “On the supply side, the banks have incentives to increase issuance of preferred shares because they are sometimes more favourable for a company’s capital structure,” he says.
Interest rates, of course, are a key factor on the demand side. “Given where bond yields have been, I think investors have been just hungry for any yield,” says Nelson. “And as bond rates have just continued to go down and down and down, all of a sudden, preferred shares really stand out.”
Yield is a key reason why institutional investors are considering preferred shares. “If you look at the dividend yield you get on your equity portfolio, it’s typically two or three per cent. The yield you’d get off your corporate bond portfolio might also be around 2.5 per cent, in many cases,” says Nelson, noting investors in preferred shares could boost their yield by up to four per cent.
There’s also the diversification element. “Preferred shares have a very low correlation to traditional asset classes,” says Ripsman. “If you look back over five years, there’s been a very low correlation with traditional common equities and a slightly negative correlation with bonds.”
Then there are interest rates. Preferred shares aren’t necessarily as sensitive to them as bond portfolios, as they don’t have the same negative response to an increase in interest rates. “It’s just not as direct of a hit as bonds in a rising interest rate environment,” says Nelson.
While there are good reasons for institutional investors to consider preferred shares, there are a few cautions. A key caution is liquidity.
“The market for preferred shares in Canada is somewhere between $50 billion and $60 billion, but not a lot of that trades on a daily basis,” says Nelson. “If, suddenly, these became desired assets for many Canadian pension plans, $50 billion to $60 billion of availability is nowhere near sufficient to match the potential demand.”
A second caution relates to the fact that the bulk of investors in preferred shares are individuals. Because individuals are the primary investors, the trading blocks are likely going to be smaller, says Nelson. “The securities have multiple listings, and it’s more difficult for institutional investors to get big blocks of shares. There’s more price discovery and a higher bid-ask spread. All these factors can impact the transactional costs.”
Tax treatment is another issue. Many individual investors like preferred shares because of the favourable tax treatment of dividends, but pension plans don’t enjoy the same advantage as they already benefit from tax shelters. In that sense, the risk-return trade-off is likely higher for individual investors than for institutions, says Nelson.
Brooke Smith is a freelance writer and editor based in Toronto.
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