Preferred shares: complex contracts, wrapped in simple investor appeal

Article content

For almost 200 years, preferred shares have been issued by companies looking to efficiently raise capital. But even over the past 25 years the preferred share landscape has evolved significantly as a result of increased trading volatility, increased regulatory oversight, and new preferred share products aimed at institutional investors.

Understanding the complexities of the preferred share market is a specialty for Doug Grieve, president of Slater Asset Management, an independent asset management firm specializing in Canadian preferred shares. Grieve founded the company in 2008 after 14 years at BMO Capital Markets — 10 as an institutional trader and four as the managing director for the preferred share institutional desk.

The traditional appeal of preferred shares for issuers is that, unlike commons shares, they’re non-dilutive, and unlike bonds, don’t show up as debt on the company’s balance sheet. While preferred shares are non-voting, they have traditionally offered investors preferential tax treatment, a priority position for receiving dividends and the potential for excellent returns — currently a spread of about 4 per cent above the Bank of Canada five-year rate. Under either an asset sale or bankruptcy, preferred shareholders often receive priority for compensation.

“It’s important for investors to remember that, historically, the preferred share is an income vehicle, not a growth vehicle,” Grieve says. “If you think a company’s going to grow, then you would choose common stock because its valuation can rise, or the company can raise its dividends.”

But the features of preferred shares continue to evolve, in large part due to regulatory oversight and efforts to capture more tax revenue from both issuers and investors. As new types of preferred shares are offered, older types remain in-market until they’re ultimately retired.

Preferred shares fall into two broad categories, fixed reset perpetuals and straight perpetuals. 

Fixed resets currently comprise about two thirds of the preferred share market. They offer a dividend rate that is pegged to market rates and reset every five years.

Straight perpetuals have no set maturity date and pay a fixed dividend with no put options — although they’re callable by the issuer on predetermined dates and at predetermined prices.

Floaters (also perpetuals) and retractables, make up less than 10 per cent of the traditional market. Floaters pay regular dividends at a rate pegged to a market interest rate. Retractables (or callables) comprise less than 1 per cent of the market and allow the investor to sell the shares to the issuer at a set price.

“At one point, preferred shares were much more like bonds and included maturity dates,” Grieve says. “But the regulators reasoned that although these shares were classified as equity, they were actually debt. Retractable preferred shares were phased out in the 1990s leaving perpetual preferred shares with call dates, but no maturity date. The evolution of preferred shares has seen them become more perpetual and more like equity.”

As part of the Basel III international regulatory framework, financial institutions also began to offer new preferred share products. In 2014, the Office of the Superintendent of Financial Institutions (OSFI) approved non-viability contingent capital (NVCC), a new class of preferred share products issued by banks. Designed to absorb losses following a bank’s financial distress or insolvency, these preferred shares offer competitive yields, but also carry unique risks. NVCC holders rank lower than others in their claims on the institution’s assets and NVCCs can be converted to common shares if the institution is under distress. If shares are converted, preferential dividend treatment disappears.

“Obviously, the issuer doesn’t want that to happen, because conversion to common stock represents a huge dilution,” Grieve says.

The initial offering of bank NVCC preferred shares were issued at a par value of $25 and are listed and available to retail investors. While some of these NVCCs remain on the market, all subsequent issues are available only to institutional or accredited investors on the OTC Institutional Bond Market, in large part to limit the volatility introduced by retail investors who frequently traded them.

“An explosion of preferred share ETFs further increased their volatility, as fund managers were often forced to liquidate shares at a rate that an illiquid asset class couldn’t handle,” Grieve says. “The focus with these newer products is on preservation of capital and reliable income.”

OTC NVCCs are issued at $1,000 per share. They currently include two products with identical five-year rate reset structures. The limited recourse capital note (LRCN) is a 60-year debt security first issued in 2021, and pays interest instead of dividends. The $1,000 Perpetual NVCC Preferred Share ($1K Pref) was first issued in 2022, pays after-tax dividends and has no stated maturity date.

While banks issue the majority of LRCNS, insurance companies can also issue them. However, the LRCNS issued by insurance companies are currently not part of the NVCC universe.

Grieve notes that the current preferred share market is extremely complex — and that complexity has only increased with the introduction of new OTC products. Each flavour of preferred share has a unique structure making it difficult to assess its true value at any given point.

“Additionally, the introduction of these newer financial products has been shifting the preferred share landscape out of the direct reach of retail investors,” Grieve says. “That means retail investors will increasingly need to rely on experienced fund managers going forward if they want to participate in this space.”

Lysander Funds offers Lysander-Slater Preferred Share Dividend Fund and Lysander-Slater Preferred Share ActivETF.

For more information on Slater Asset Management, visit: https://www.slaterassetmanagement.com.

For more information on Lysander Funds, visit: www.lysanderfunds.com

The views and information expressed in this article are for informational purposes only. They are not intended as investment, financial, legal, accounting, tax or other advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.

Lysander Funds Limited pays a fee to Postmedia for content generation in public communications including media articles such as this article, which may be construed as promotion of Lysander Funds Limited, its affiliates or the Lysander Funds.  

®Lysander Funds is a registered trademark of Lysander Funds Limited.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Lysander Funds Limited, who is a member and content provider of this publication.