In this yield chasing environment for income investors, it’s harder and harder to find decent yield in the low-interest rate, high P/E stock market environment. One option is to purchase Preferred Shares on the stock market for their high yield. But this option can potentially be dangerous as we will explain.
If you’re not aware of what preference shares are, here is a quick education. Preferred shares are yielding, market traded, corporate debt. They pay a rate and are traded on the stock market rather than the bond market. They are something in between bonds and common stock, but they share more in common with bonds. They are essentially bonds that usually don’t have a set expiration date that are bought and sold on the stock market, but there are a few very important differences between preferred shares and bonds.
The Differences:
They are called “preference shares” because the holders of these shares get preference as creditors, much like bonds, but they only receive preference over common stock. Bondholders have preference, if you will, over preferred shareholders and this can be a possible pitfall to shareholders. i.e. if the company that issued the preferred shares defaults on their debt, then bond holders will be paid before preferred shareholders in liquidation. 99 times out of 100, this means the preferred shareholders would receive zilch.
Preferred shares are generally perpetual, in that they don’t have a set redemption date like a bond. But, they all have a call price that the issuing company can use to buy back the preferred shares at any time. This can be a problem in an environment of rising yields. The company that issued the preferred shares can simply buy their shares back and reissue them at a lower rate. Before you even consider investing in a preferred share issue, be sure to check what the buy-back price is to ensure the issuing company doesn’t buy them back from you at a discount.
In an environment of rising interest rates (as we are likely seeing now), you can see the price of your preferred shares rapidly decline as their coupon rate becomes less attractive when compared to the rising rate of bonds.
So, having read the above, you’re asking “just what are the advantages to preferred shares?” Well, generally they are higher yielding than most bonds as they do not have a set expiry. Another advantage is the stock market is much more open than the bond market (unfortunately) and you thusly pay much lower rates when buying preferred shares (just the brokerage fees, really). Additionally, if you don’t have much money to invest (hard to imagine for me as a billionaire), you can buy preferred shares in any quantity, whereas bond purchases are generally sold by brokers in blocks. However, this can be avoided by buying bond ETFs like the target maturity bond ETFs we wrote about yesterday.