October « 2008 « tarik.ca analytics : a canadian financial blog

Question

I would be interested in what you think of preferred shares currently – the yields are very high! My concern is about inflation in the longer term and higher interest rates. In your article you mentioned the “large risk” of the shares never being redeemed. I would be interested in your opinion on that risk today?

Thanks,
Sharron

Answer

Hello,

Because preferred shares (most of the time) are structured as perpetuals there is no obligation for the corporation issuing preferred shares to redeem them in the future.

If we ever enter a secular bull market in interest rates, preferred shares will be hit the hardest out of all debt-based instruments, due to the fact that they have an infinite maturity date (Hence they have to be re-discounted to infinity).

Consider the following example: From the highs in the late 1960’s to the lows in January 1980, long term corporate bonds fell by over 60% as interest rates rose from 3% to 18%. As the prices and yields of preferred shares closely follow long-term corporate bonds, we should expect preferred shares to perform similarly to long-term corporate bonds in the future.

In such a scenario, preferred shares would be hit even harder than long-term corporate bonds because there would be no intensive for firms to redeem preferred shares, as they would have to roll over the debt to higher interest rates. This will cause the Present Value of principal amount of the share to go to zero, unlike bonds.

If your goal is to protect your money while investing in preferred shares, you should look into floating cumulative preferred shares of Investment Grade companies, these preferred shares will move with interest rates, hence protecting your initial principal of your investment. While you might be getting a smaller yield, your principal is better protected whether we enter a deflationary of inflationary environment.

Go to http://www.prefinfo.com/
Search for “Floating” Preferred shares which and you will find a couple dozens of them. Note most listed floating preferred shares are currently not floating but have dates in the future where they will start floating.

Cheers,
Tarik