For years, the prime example of a well-diversified portfolio was the “60/40” portfolio – that is, 60% allocation to stocks and 40% allocation to bonds. This portfolio typically provided a favorable mix of upside potential from its exposure to stocks, along with the diversification benefits of bonds which offset losses in years when the stock market faced a downturn. Investors were able to hold this portfolio mix (with occasional rebalancing) and reap the benefits of above-average risk-adjusted returns.
2022 was a year where, uncharacteristically, both stocks and bonds took big losses. The largest Canadian stock ETF by assets, iShares S&P/TSX 60 Index ETF (XIU) returned -6.6% in 2022 (perhaps helped somewhat by the overweighting of the Energy sector) while in the bond world the largest Canadian bond ETF by assets, BMO (TSX:BMO) Aggregate Bond Index ETF (ZAG), returned -10.1%, with rising yields crushing bond prices.
Consequently, Canadian investors may want to look outside of these two traditional asset classes to diversify their portfolio – enter preferred shares.
What are preferred shares?
Preferred shares can be thought of as a hybrid between both stocks (common shares) and bonds as they possess characteristics from both asset classes.
Considered a type of stock, preferred shares have a higher priority in receiving dividends AND a higher claim to assets in the event of a bankruptcy – making them less “risky” than traditional common stock. However, while they have a higher entitlement to assets than common shareholders in the event of a company liquidation, they retain a lower claim to assets than bondholders.
Tale of the tape: preferred shares vs. stocks
Against stocks, preferred shares typically have:
- Higher rights to dividends
- Higher claims to assets in a bankruptcy
- Less capital appreciation
- No voting rights
- Potential to be convertible to common shares
Based on these characteristics, you can start to picture how preferred shares are more like bonds than stocks, i.e., greater income potential, less capital appreciation and less risk.
Tale of the tape: preferred shares vs. bonds
Against bonds, preferred shares typically have:
- Periodic cash payments (similar to a coupon from a bond)
- Less income potential (dividends are not guaranteed and are at the issuers’ discretion)
- No maturity date
- Lower claims to assets in a bankruptcy
These characteristics highlight the comparability and contrast between preferred shares and bonds which may make them more or less suitable depending on investor preferences – with bonds more favorable for a lower-risk investor with a fixed investment horizon.
Why should you consider a preferred share investment?
Preferred share investments could be a solid choice for investors who wish to avoid the volatility of stocks, yet are seeking a greater yield than bonds. The primary advantages of using this security include:
- Higher dividends. Greater yield potential from preferred share investments, which is attractive in a recessionary environment where growth will be volatile
- Convertibility. Preferred share investments will sometimes have the potential to benefit from the upside of a common stock, while limiting the downside. This is because some preferred shares can be converted into common stock. Thus, if a share price increases in value significantly – preferred share investors can exercise their conversion option to capitalize on this increase. If the share price is stagnant or decreases, the preferred share investor can refuse to exercise their conversion and continue collecting preferred share dividends.
- Higher claim to assets. The largest risk to common shareholders is a bankruptcy where the common shares could potentially be worthless – preferred shareholders are insulated to a greater degree from this risk as they contractually and legally have greater protection rights in the event of a company’s liquidation.
As a summary of how preferred shares stack up against both stocks and bonds in terms of investment characteristics:
Claim to assets: Bondholders > Preferred shareholders > Common shareholders
Capital gain: Common shareholders > Preferred shareholders > Bondholders
Income: Bondholders (in most cases) > Preferred shareholders > Common shareholders
Potential return: Common shareholders > Preferred shareholders > Bondholders
Preferred share ETFs for Canadians
ETFs are a viable way for the average investor to gain exposure to preferred share investments. While some preferred stocks are accessible through online brokerages – they are usually thinly traded. This makes it difficult for investors with smaller amounts of capital to invest in preferred shares in a cost-effective way. ETFs pool investors’ funds together making it easier to take preferred share positions at a more favorable cost.
An ETF that Canadians can use to gain preferred share exposure is:
BMO Laddered Preferred Share Index ETF (ZPR)
A highly liquid, low-cost preferred share ETF focused in the Canadian space. Highest sector exposures (as of October 31, 2022) include: Banks (33%), Oil & Gas (21%), Asset Management (7%), and Life & Health Insurance (7%).
- AUM: $1.7B
- Expense Ratio: 0.50%
- YTD Return: +5.7%
Data as of January 23, 2022.
This content was originally published by our partners at the Canadian ETF Marketplace.