A quick update on the status of this blog:
It’s been a while since I’ve updated this site, mostly because I’m lazy, but also because the site isn’t achieving its main goal. That goal being an attempt to earn passive income. Apparently it takes countless hours of writing quality, useful, and entertaining content to do that! This is my first attempt at public writing and website building. I think I’m doing pretty decently for a first attempt. But as far as generating a profit? I would have been better off getting a part time, minimum wage job. And yet here I am writing more, which brings me to the reason I keep writing despite a lack of financial gain – To figure things out and organize my thoughts. Also it’s kind of fun. And I like seeing the view counter go up and down. Also I like reading comments, especially from non-blood relatives (not that I don’t enjoy those as well).
They say the best way to learn something is to teach someone else. I figure if I can’t explain something in my own words then I don’t understand it, which is why a lot of my content is an attempt to explain complex topics like swap ETFs or the Canadian Pension Plan. But based on page views then most of you just want to hear me rant about BMO (My BMO rant nearly has more views than all other posts combined).
I have a few articles half written but I don’t think they’re ready for action yet, and may never be, mostly because they bore me. And if I’m bored you are definitely bored. Lately I haven’t found any interesting finance topics that I might actually invest in. That is, until now. Let me attempt to explain Preferred Shares:
I’m guessing many of you have never even heard of preferred shares (henceforth written as PS). But before we explain PS we must first define PS. How do you choose a PS? Why would you avoid PS? and what makes them so preferred?
Defined in a few words – A stock where you get first dibs on company payouts.
- PS are an investment product similar to stocks, bonds, GICs, etc.
- They can be thought of as a hybrid between a regular stock and a bond.
- They are issued by corporations in addition to their common stock.
- They normally include an attractive dividend that is fixed at the time of PS issuance (unlike common stock dividends that change over time)
- The payment is considered a “dividend” instead of a “distribution” meaning the government taxes it more favorably than income from a bond, REIT, or GIC.
- You can buy them like any other stock on an exchange like Questrade.
- You should consider owning them in taxable accounts, for their high dividend and diversification benefits.
Even more details:
What makes them “Preferred”?
PS get first dibs on company dividend payments. If they don’t have enough to pay to all common stock holders the PS owners get paid first. And payments cannot be skipped as they are legally binding. In the event the company goes bankrupt the PS owners get paid out first. Unlike common stock owners who may get nothing the PS owners will likely get something during the liquidation of the company’s assets.
What are the main advantages?
Tax-favorable dividends – In the eyes of the government there are two kinds of investment payouts – Dividends and Distributions. A dividend from a Canadian corporation is normally referred to as an “eligible dividend”, meaning it is taxed more favorably than regular employment income (more details at taxtips.ca). A “distribution” is often considered interest income and is taxed at your marginal tax rate (i.e. it adds to your total taxable income for the year). Preferred Shares pay the more tax favorable dividends, rather than distributions.
Diversification – PS aren’t closely correlated with stock price or bonds, and thus are useful for those of you looking for further diversification.
What are the main disadvantages?
Non-voting Ownership – If you own a PS, you have ownership of the company, HOWEVER, you don’t get to vote on leadership decisions. But come on, lets face it, us chumps investing less than 7 figures aren’t going to be voting anyway so non-voting rights is a moot point. If anything it’ll be nice to not get all these voter card letters in the mail.
Interest Rate Risk – Similar to bonds, the cost of preferred shares is largely dependent on interest rates. Since the dividend is fixed for the term of the PS, any rise in interest rate will cause the PS price to drop. If you own a PS paying 5%, and suddenly interest rates rise to 6% it would be in your interest to sell the original and buy the higher paying PS. Thus the price of the original PS will decrease. Conversely a drop in interest rates will cause your PS to rise in value.
Lack of Capital Appreciation – Unlike common stock where the dividend will rise over time, the PS dividend is fixed. Thus if the company does especially well and/or raises the common share dividend the common shares may increase in value but the PS likely won’t move. Conversely the PS should retain more value if the company does poorly. (this is why the PS somewhat acts like a bond)
In what situation should I buy preferred shares?
If you are investing in a tax sheltered account (TFSA, RRSP, RESP) you don’t need to worry about PS unless you’re looking for more diversification. And if you own index funds you’re likely diversified enough already.
However if you have a taxable investment account then you can take advantage of the PS dividend’s preferential tax treatment. When looking for safe dividends I normally consider blue chip stocks like Bell, which pay a 4-5% dividend. Or REITs, which pay 7-10% distribution (which is taxed as marginal income, and comes in closer to 4-5% afterwards). As of this writing I own this PS in my taxable account which is earning a 9% annual dividend and not subject to the high tax rate of my similar REITs.
So there you have it. Buy some preferred shares. Or don’t. Hopefully you at least understand them now.
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