Why I Prefer to Avoid Preferred Shares | Common Sense Investing

TL;DR

Preferred shares offer higher yields and tax benefits, but they come with additional risks and complexities compared to bonds.

Transcript

this is the second video in a multi-part series about alternative investments in the first video in this series I told you why high-yield bonds fall short on a risk-adjusted basis and should only be included in your portfolio in small amounts through a well diversified low-cost ETF if at all if you haven't watched it yet click here and by the way I... Read More

Key Insights

• ✳️ Risk and return are always related, and preferred shares come with additional risks and complexities compared to bonds.
• 😘 Preferred shares have lower priority in bankruptcies and do not participate in the growth of the issuing company.
• ☠️ Fixed reset preferred shares have a five-year fixed dividend, which is reset based on the government bond yield, reducing interest rate risk.
• 🤨 Companies issue preferred shares when they cannot raise more debt or want to diversify their capital structure.
• ☠️ Preferred shares can be attractive for income-oriented investors who pay high tax rates on eligible dividends.
• ⛔ The risks of preferred shares make them unsuitable for individual investors, and it is recommended to limit their allocation and diversify broadly.
• ❓ Individual preferred shares should be avoided due to their complexity.
• 🪗 Substantial risks and complexities of preferred shares make them inappropriate investments for individual investors, according to Larry Swedroe's book.

Questions & Answers

Q: How do preferred shares differ from bonds in a bankruptcy scenario?

In a bankruptcy, bondholders are paid first, followed by preferred shareholders, and then common stockholders. Preferred shares do not participate in the company's growth and have lower priority, increasing the risk of not receiving any payment in a bankruptcy.

Q: Are preferred shares exposed to credit risk?

Yes, long-term fixed income, including preferred shares, exposes investors to credit risk. If the issuing company cannot pay dividends for a prolonged period, the investor's income and return are at risk.

Q: What are the risks associated with perpetual preferred shares?

Perpetual preferred shares lack maturity dates and have a call feature. If interest rates fall or the issuing company's credit rating improves, the shares can be redeemed at the issue price, capping the investor's upside.

Q: Why would anyone invest in preferred shares despite the risks?

Preferred shares offer higher yields compared to corporate bonds and can be taxed as eligible dividends for Canadian investors. They also provide diversification benefits as their returns have imperfect correlation with other asset classes.

Summary & Key Takeaways

• High-yield bonds are not recommended for portfolios, and preferred shares are an alternative income-seeking investors may consider.

• Preferred shares have a lower priority in a company's bankruptcy and do not participate in the company's growth.

• Fixed reset preferred shares have a fixed dividend for five years and are reset based on the five-year Government of Canada bond yield, reducing interest rate risk.