What are Preferred Shares?
Preferred shares are unique, they do have their upsides and they do have their downsides.
Preferred shares are a kind of mixed entity that has both fixed income and equity characteristics. The main reason why I was drawn to them is because of the fixed distribution (for example, ZPR.TO pays about a high yield) and fixed income. They are tax efficient as well and are best kept in a non-registered portfolio. Unlike bonds, the income from the yield is taxed like a Canadian dividend and given a preferential tax rate. Income from distribution from bonds is taxed at your marginal rate.
There are four different types of preferred shares:
- Rate Resets
For more information on Canadian preferred shares, Bank of Montreal has a nice PDF explaining what the different types are and the benefits of preferred shares.
When interest rates fluctuate and drop, there is an increased risk of volatility with preferred shares. The Canadian Preferred Shares tanked while common stocks did well in the past year. With the recent Bank of Canada announcement of decreased interest rate, my Canadian preferred shares took a large hit. This Globe and Mail article explains what investors should know about the recent plunge in Canadian preferred shares.
What You Should Do if You Want Preferred Shares in Your Portfolio
If you do plan to include Canadian preferred shares in your portfolio, according to ETF guru, Canadian Couch Potato, there are a few things that you can do to limit your risk.
Limit the percentage allocation of Canadian preferred shares in your portfolio. You should have a maximum of 5% to 10% of your portfolio in Canadian preferred shares. For me, I was obviously chasing yield too much (aiming to increase my dividend income can backfire) and I estimate I have over 20% of my total portfolio in preferred shares.
Keep your preferred shares in a non-registered portfolio. If you keep it in the TFSA or the RRSP, any tax advantage that you can get for capital loss is not available to you. Thankfully I did this right, however, I do have a small portion of CPD shares in my TFSA (because I was OCD and liked to keep my ETF portfolios together).
Canadian Couch Potato also recommends not to buy individual preferred shares. An exchange-traded fund such as ZPR provides more diversification as it has coverage of over 140 different issues and has a low Management Expense Ratio of 0.45%.
Of course, all this depends on your time horizon, risk tolerance, and your own situation (e.g. whether you need income versus growth and capital preservation), among other reasons. For example, if you don’t plan to need the money for a long time (think 10+ years) the recent paper loss in preferred shares shouldn’t phase you. On the other hand, if you are planning to use the money in the next 1-3 years, something that will be less risky is probably a better bet.
For further information on preferred shares, the Financial Post article “What Investors Need to Know about Preferred Shares” is a good introduction to the risks associated with preferred shares. Also, Finiki (the Financial Wiki for Canadians) has a great article on Canadian preferred shares as well.