4 Preferred Shares Yielding 8%+

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Chances are, most of you reading don’t really know what preferred shares are. And if you do, they’re more of a distant concept than something that you really understand.

I’m here to change that, because preferred shares can really be an effective security for the enterprising income investor. In fact, your author has dabbled into preferred shares a few different times, making 20%+ annual returns each time by following a general formula.

But more on that later. First, let’s look at what exactly a preferred share is, what you need to know about the market, why I think today is a great time to buy, and four different preferred shares I find pretty interesting today.

First, what’s a preferred share?

Preferred shares are the Marie and Donny Osmond of the financial world. They’re a little bit equity and a little bit bond.

I just lost everyone under 50 with that description, didn’t I?

The dictionary definition of a preferred share is a security that sits between a bond and common stock on the corporate ownership hierarchy, meaning they have a higher claim to dividends than common stockholders, but rank below the various forms of bondholders. If there’s a bankruptcy, various bondholders get paid first, then preferred shareholders, then common shareholders.

Companies issue preferred shares for all sorts of different reasons, although they normally just end up being a substitute for debt most of the time. Because they rank below all other forms of debt, investors generally demand a higher yield (at least compared to the debt) in exchange for taking the extra risk involved.

Most forms of debt trade over the counter, an opaque market most retail investors avoid. Preferred shares have the advantage of trading on the stock exchange, with most in Canada identified with the .PR extension.

So, as an example, BCE’s preferred shares would trade at BCE.PR.A, BCE.PR.B, etc. Each different ticker symbol represents a different preferred share, each with its own special rules and conditions.

Unlike common shares, preferred shares don’t have a say in company operations. Common shareholders get to vote on who is included in the board of directors, approve mergers, etc. Preferred shareholders don’t have those same rights.

Preferred shares also pay dividends, not interest, meaning if an investor holds them in a taxable account they get the dividend tax credit. This effectively increases their yield, at least when compared to a similar bond.

There are a butt-load of different types of preferred shares, but we’ll just cover the main ones. They include:

Perpetual: These have no fixed term date and pay dividends for as long as they’re outstanding. These are the most sensitive to interest rate movements. They’re also the easiest to understand.

Rate-reset: These are the most common type of preferred shares in the Canadian market today. These pay a set dividend for a period of time (five years, usually), then the rate resets at a predetermined premium compared to a benchmark, which is usually the Bank of Canada five-year bond rate. If interest rates go up, these preferred shares will pay more, with the payout shrinking if rates go down.

Convertible: These preferred shares convert to either a new series of preferred shares or common shares after a set date. Many rate-reset preferred shares come with the option to convert to a floating rate when they reset, but shareholders don’t usually convert.

Floating rate: These preferred shares have a floating dividend, which is usually tied to the Bank of Canada’s overnight rate.

You can buy individual preferred shares or own them passively via a mutual fund or an ETF. Some investors like owning every preferred share via an ETF, but this analyst is no fan of that approach. We want to cherry pick the best preferreds, taking advantage of an extremely inefficient market.

One last note. Individual preferred shares are extremely illiquid. Always use limit orders when buying and don’t chase prices. Discipline is needed here.

How I play preferred shares

Let’s talk about how the preferred share sector generally works before we get into how I play it.

A company needs to raise some money for whatever reason, so they issue some preferred shares. A typical preferred share issue might be worth $250M.

Institutional buyers immediately gobble up most of the $250M, if not all of it. I’m talking insurance companies, fund mangers, pension funds, etc. They’re looking for higher yields just like the rest of us are, and will usually leap at the opportunity to lock them in. If any makes it down to retail investors, it’s not much.

This creates an incredibly illiquid market for most preferred shares. Some will regularly go days without trading, and when they do trade it’ll only be a few hundred shares a day. These institutional buyers are incredibly patient and don’t sell easily.

Most of the time the preferred share market is incredibly boring and isn’t worth a minute of your time. But sometimes, once every few years or so, this illiquidity turns into your advantage as a bunch of investors get nervous about preferred shares all at the same time and the entire sector gets hammered.

This is exactly what has happened over the last year. Here’s a one-year chart of CPD, the largest preferred share ETF in Canada, and a fine proxy of the asset class as a whole.

That’s a 15% decline, and it’s on top of another 10% decline during the previous year. We’ve officially hit the point where the sector becomes interesting.

The longer-term chart shows this happens once every few years, and the market always comes back. Here’s a ten year chart of the same ETF:

I played the big decline in 2016, buying Aimia and Cannacord Genuity preferred shares after they collapsed. I did so again in 2018, this time picking up TransAlta and Brookfield Asset Management preferreds. I didn’t bother in 2020, since there were too many great deals out there to bother with preferred shares.

Each time I dabbled in the market I made excellent returns, surpassing 20% (including dividends) annually each time, usually getting out within 12-18 months after buying. I viewed the strategy as a trade, but you could easily view it as a more permanent income play, locking in a succulent yield for the long-term.

The rules are simple. Ignore the preferred share market until it collapses. Then, when it does, methodically go through the entire market company by company and see what’s interesting.

Or you can just let me do it for you. Here are four interesting preferred shares I’ve found in the market today.

BCE

Part of the reason why more people don’t buy preferred shares is they’re complicated sets of securities with their own language, something that exists likely because their main market is institutional buyers.

I’ll do my best to explain, but be warned. The complexity is one reason why the opportunity exists. I know the language of preferred shares, and even then it takes me a while to get up to speed.

Let’s start with BCE’s preferred shares, specifically the series AD edition. These trade under the ticker symbol BCE.PR.D, and are a floating rate preferred. These preferred shares have a complex payout schedule that starts at 80% of the Government of Canada prime rate and goes up to prime as the underlying price of the security falls.

My back of the envelope math gives us a current payment of just over $0.14 per share each month, which works out to a yield of approximately 9.4% — a yield much higher than prime because this security trades for just over $17 per share.

Essentially, this preferred share boils down to this. Investors who buy today can lock in a yield of Prime (on the original $25.50 par value, anyway) which will go up as rates go up. The downfall is the rate will fall as prime goes down, although that should be offset by the price of the underlying security increasing. The current rate rules are locked in until 2028, too, meaning there’s only a minimal rate reset risk.

I’m not going to spend much time analyzing the credit worthiness of BCE. That bad boy is solid.

Fairfax Financial

Your author isn’t really a fan of Prem Watsa, the man behind Fairfax Financial. Watsa predicted the 2008 mortgage crisis and Faixfax made billions off that call. Emboldened by this success, he then made a series of poor macro bets that wiped out a lot of those profits.

In his defense, the capital allocation decisions lately have been better.

As much as I don’t care for Watsa the capital allocator, I’m the first to admit the insurance operations are pretty solid, which bodes well for the overall financial health of the business, something that makes the preferred shares pretty damn safe. Combine that with several series of preferred shares yielding more than 10%, and it’s a compelling opportunity.

Let’s look specifically at the series F preferred shares, which paid $0.419 per share in the previous quarter. Annualize that and we get a 10.2% yield, and it’s backed by one of the world’s most secure insurance companies.

The credit worthiness of the issuer isn’t the problem here. This preferred share has a floating rate payout, but at least it’s easier to figure out than BCE’s. The rate is 2.16% above the prevailing Government of Canada three-month T-Bill rate, which is currently right around 4.7%. Add the two together and we get a current payout of 6.86% based on this share’s par price of $25. That translates into an annual payout of $1.71 per share, although that will change each quarter depending on the T-Bill rate. The current yield based on today’s price and the adjusted payout is 10.5%.

The risk is the same as the BCE preferred — what happens when rates go down? You’ll get less income, but that should be offset by an increase in the underlying price. And if rates stay about the same as today — or even go up — then you’re laughing all the way to the bank.

One last quick note on this one. This preferred share goes ex-dividend on June 15th, meaning if you buy today you won’t get a dividend until the end of September. The BCE preferred share, meanwhile, will pay monthly starting July 12th if someone buys it today.

TransAlta

As mentioned, the problem with floating rate preferred shares is nobody really knows where interest rates will go. Even the Bank of Canada’s Governor has no idea:

If the guy in charge of the freaking Bank of Canada can’t predict interest rates, what chance do mere mortals like us have?

With that in mind, let me present a couple of ideas where the interest rate is locked in, at least for a few years. They’re kind of like GICs on steroids, but with the caveat that the price could very well go down if rates keep marching higher.

The first comes from TransAlta, more specifically the TransAlta Series E preferred shares that, for some reason, trade under the ticker symbol TA.PR.H.

I’m the first to admit TransAlta is a meh power generator, one that has suffered from a milady of issues over the years. All of the good assets were quietly transferred to TransAlta Renewables, leaving a lot of coal-fired plants in the portfolio. These have been converted to natural gas, and the company has quietly improved its balance sheet and improved its profitability. It’s still not something I’d look at buying — I think Capital Power is a far better way to play the space — but it’s fine as a preferred share investment.

The opportunity goes something like this. The Series E preferred shares reset at 6.89% back in September, 2022, locking in the rate for five years. This translates into a dividend of just over $0.43 per share each quarter, or $1.7235 each year. Yes, it’s important to go to four decimal places for some reason.

This preferred share currently trades at $21 each, giving us a yield of 8.2%. That’s right around a 52-week low and is down by approximately 15% over the last year.

One reason why TransAlta preferred shares might be cheap is the company has a history of cutting its common dividend. But the last cut was nearly a decade ago, and the common dividend has been increasing over the last few years. The balance sheet is fine, too. The payout is safe.

Just like the Fairfax preferred share, these went ex-dividend yesterday. So if you buy today, you’ll get your first dividend September 30th.

Brookfield Office

This last one is if you’re really feeling frisky. It’s a far higher risk than the rest, but as you’ll see, the yield sure is exciting.

Office space doesn’t need much of an intro in 2023. It’s probably one of the more controversial investments in the market today, with people split pretty evenly on whether it’s a good value or it’s going to zero forever. I think it’s the former, but I’m the first to admit I might be wrong here. People are only trickling back into the office. I thought by now it would be more of a bigger wave.

Brookfield amassed an excellent portfolio of real estate over the years, buildings that persistently traded at a discount to what management felt fair value was. Finally, in 2020, management just threw up their hands and offered to take the whole thing private, essentially hiding it on the balance sheet of Brookfield Corporation and giving investors less disclosure than before. The goal was to quietly right the ship and then, when conditions improve, flip it back onto the stock exchange and cash out — although that plan wasn’t really said out loud.

Unfortunately, that plan hasn’t exactly worked out. Brookfield’s retail portfolio — remember, it agreed to buy Simon Properties in 2019 — has recovered pretty nicely, but the office portfolio is still a dud. The company even went as far as intentionally defaulting on some mortgages, even though it has the cash flow to service them.

A quick look at Brookfield’s 2022 annual report tells us the company generated US$5.2B in distributable earnings, yet it defaulted on mortgages? Even the real estate division generated nearly US$1B in funds from operations.

That move really threw cold water on the remaining Brookfield Office preferred shares, causing yields to spike.

Specifically we’ll look at the Series II (BPO.PR.I), which just reset back in April at a 6.36% yield — based on the $25 par price. The current payout is $0.397 per share each quarter, or $1.588 per year.

This preferred share currently trades at $14.05, giving it a yield of 11.3%. And it just reset in January, meaning you’ve locked in that payout for almost five years. After that, it resets at the greater of the GoC five-year bond rate plus 3.23% (which combines to give us a yield currently close to 7%) or 4.85%. And remember, that rate is based on the $25 par price.

The devil really is in the details on this one. Like all preferred shares, this one is higher on the capital structure than the common shares, meaning Brookfield can’t send dividends back to the parent without paying preferred shareholders. That’s a good thing. But remember, Brookfield already strategically defaulted on mortgages. It might very well do the same thing on some of its preferred shares.

Hell, I’ve even seen certain investors (okay, just one crackpot in my Twitter DMs) that think the company will refuse to pay preferred shareholders, watch the shares tank, and then repurchase them for a song.

This is a good time to note this particular preferred share is a cumulative preferred share, meaning it must make up any dividends missed before it can pay common share dividends. The common shares are owned by Brookfield, meaning preferred shareholders must be paid before Brookfield can transfer money out of its real estate operations.

At least I think. This is all very opaque.

That’s why a double-digit yield is available today. Because of the four preferred shares I’ve featured, this one is by far the highest risk. But it also has the highest potential upside if sentiment turns. Back in 2019, this preferred share traded for more than $23. That’s more than 60% upside, plus the dividend.

And if you’re really feeling frisky, there are 13-14% yields available on Brookfield Office floating preferred shares. Check out BPO.PR.X for that one.

The bottom line

This turned out to be one of my longer pieces, almost getting to 3,000 words. That’s because preferred shares are complex and tough to explain in an easy-to-understand matter. Y’all might have questions, and I encourage you to ask them if you do.

This is the main reason why alpha exists in the asset class. They’re needlessly complicated and clearly not marketed towards retail investors.

But for those of us who are willing to do a little work, there’s an opportunity here. At this point I’m not taking advantage of any, but that’s just because I’m a little short of cash at the moment. Taking 12-18 month positions in preferred shares doesn’t really mesh well with my buy-and-hold forever mentality, either. But I’m still interested, and I’ll be keeping an eye on the market. I still think it’s a nice opportunity today.

Author has no position in any preferred shares listed. Nothing written above constitutes financial advice. Consult a qualified financial advisor before making any investment decisions.