Portfolio, Action & Research Team

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1 Portfolio, Action & esearch Team Pat Keene May 10, 2010 Preferred Shares An Introduction Preferred Share is a class of equity that ranks senior to common equity. Preferred shares are an important source of capital for Canadian corporations, as they neither add to debt nor dilute common equity. Income-oriented investors are attracted to the relatively high and tax-efficient dividends that preferred shares pay. In this publication, we take a look at the Canadian preferred share market and the different types of shares in the marketplace. Credit Quality As payment is not a legal obligation, preferred shares are generally viewed as a higher-risk investment than highgrade bonds and GICs. Consequently, it is important to consider an issuer s financial condition and business outlook as part of the investment decision. Two Canadian credit rating agencies Dominion Bond ating Service and Standard and Poor s ating Service provide credit ratings for many preferred shares. These credit ratings, which range from the highest P-1 to the lowest P-5, are defined in Appendix A. Preferred shares that are rated P-1 or P-2 are considered to be among the strongest credits. Financial institutions and companies that have a relatively stable operating profile are typically granted such ratings. A P-3 rating is generally reserved for businesses that are sensitive to economic cycles. A P-4 rating denotes a relatively high level of operating or financial risk. All else equal, the lower the credit rating, the higher the potential risk of non-payment. Moreover, lower-rated preferred shares generally lack liquidity and may exhibit more price variability over time than higher-rated issues. Preferred shares that are rated P-1 or P-2 are recommended for conservative, income-oriented investors. Dividends Most preferred shares are issued with a $25 par value. The annual dividend ( coupon ) is expressed as a percent of par value (such as 5.20%) or a dollar amount (such as $1.30). Dividends are usually paid quarterly. Preferred share dividends are paid in priority to common share dividends, but only after interest payments are made to debenture holders and other creditors. If a company were in financial distress, it would have to eliminate its common dividend before it would be allowed to reduce or suspend dividend payments to its preferred shareholders. Member-Canadian Investor Protection Fund

2 2 Preferred Shares, An Introduction May 2010 Preferred share dividends are either cumulative or non-cumulative. A cumulative dividend, if suspended, would accrue and would have to be paid in full before common dividends could be reinstated. A noncumulative dividend, if suspended, would not accumulate. Today, most financial preferred shares are non-cumulative, while industrial issues are cumulative. Canadian corporations pay preferred share dividends out of after-tax earnings. Consequently, by the time individual investors receive the dividends, they have already been subject to tax once. To alleviate double taxation, individual investors are eligible for the dividend tax credit. The effect of the Table 1: Combined Top Marginal Tax ates 2010 Eligible (1) Salary & Capital Province Dividends Interest Gains Alberta 15.88% 39.00% 19.50% BC 21.45% 43.70% 21.85% Manitoba 25.09% 46.40% 23.20% New Brunswick 19.46% 46.00% 23.00% Newfoundland 24.37% 44.50% 22.25% Nova Scotia 29.80% 48.25% 24.13% Ontario 26.57% 46.41% 23.20% Prince Edward Island 25.95% 47.37% 23.69% Quebec 30.68% 48.22% 24.11% Saskatchewan 21.64% 44.00% 22.00% Note: This information is intended for inllustration purposes only. Source: dividend tax credit is that the combined top marginal tax rate for eligible dividends is significantly lower than for interest income, as highlighted in Table 1. Preferred Share Features edemption All preferred shares have a redemption feature. edemption is the issuer s privilege to buy back its preferred shares at par value or at a small premium (the redemption price ) on specified dates. Typically, a preferred share becomes redeemable five years after it is issued, and can be redeemed at any time thereafter. Since all preferred shares are redeemable at some point, an investor must consider the return to the redemption date (the yield-to-redemption ) when making an investment decision. The decision to redeem a preferred share or leave it outstanding usually depends on the issuer s outlook for interest rates and its refinancing options. However, an issuer must consider other factors, such as the credit, taxation and regulatory environment, as well as investor appetite. Issues that are expected to be redeemed within a relatively short period of time will trade close to their redemption price. Certain issues allow for the payment of redemption proceeds with common shares rather than cash. The feature, known as soft redemption, is described on Page 3. A soft redemption feature is rarely exercised, as it would dilute common equity. etraction A small number of preferred shares have a retraction feature. etraction is the investor s privilege to tender their shares back to the issuer for par value on specified dates (the retraction dates ). A retraction feature is considered defensive, as it helps support the share price in a rising interest rate environment. 1 Eligible dividends are those paid after 2005 by public Canadian corporations to Canadian resident individuals and designated as eligible dividends. This encompasses most dividends from Canadian public corporations.

3 Preferred Shares, An Introduction May While a retraction feature is considered bond-like, payment on the retraction date is not a legal obligation. If an issuer were financially distressed and unable to meet a retraction deadline, the value of the preferred share would fall substantially and shareholders would suffer a loss. Certain issues allow for the payment of retraction proceeds with common shares rather than cash. The feature, known as soft retraction, is described below. A soft retraction feature is rarely exercised, as it would dilute common equity. Soft edemption and Soft etraction Certain issues allow for the repayment of redemption or retraction proceeds with the issuer s common shares rather than cash. An issuer would likely exercise this privilege only if cash were not readily available on a retraction date, or under other unusual circumstances. The number of common shares that one would receive for every preferred share held would be calculated as follows: = edemption price (plus accrued dividends) The greater of (i) $2.00; and (ii) 95% of the weighted average trading price of the common shares during a specified 20-business day period. Example: ABC Company 6.0% Cumulative Preferred Share was redeemed on October 29, The issuer chose to pay redemption proceeds with its common shares instead of paying $25.00 cash per share. The average weighted trading price for ABC Company common during the prescribed 20-day period was $ = $25.00 (0.95 x $41.28) = $25.00 $ = ABC Company common shares = x $41.90 = $ When shares were distributed, ABC Company common was trading above the 20-day average, at $ Consequently, when preferred shareholders received ABC Company common per preferred share, the value was $26.71 per preferred, a positive outcome. However, had ABC Company common shares traded substantially lower at the time, shareholders may have suffered a loss.

4 4 Preferred Shares, An Introduction May 2010 Types of Preferred Shares The following is a brief description of the four main types of preferred shares: etractable, Straight, Fixed-eset and Floating-ate. etractable A etractable preferred share pays a fixed dividend and has a retraction feature. The term to the retraction date is usually five to 10 years. etractable preferred shares are primarily valued on the return to the retraction date (the yield-to-retraction ), but holders must also consider the yield-to-redemption. etractable issues are among the lowest yielding type of preferred share due to their defensive features and strong supply and demand fundamentals. etractable shares are popular because, as mentioned earlier, a retraction feature helps support the share price in a rising interest rate environment. As illustrated in Chart 1, the price of a highquality retractable preferred share will be relatively stable over time, despite changes in bond yields. Chart 1: etractable Preferred Price vs 10-Year Canada Bond Yield Bond Yield (%) 6.5 Bond Yield 6.0 Share Price Preferred Price ($) 3.0 While retractable preferred shares are popular among investors, from a company s standpoint 31-Mar Sep Mar Sep Mar-10 there are several negative implications of Date issuing them. First, they are not eligible as Source: Tier 1 Capital, which is particularly relevant to Canadian banks. Second, Canadian accounting rules generally require that retractable issues be treated as a liability, similar to debt, on the issuer s balance sheet. Finally, rating agencies view a retraction feature as a financial burden, and may grant a lower rating on a retractable issue than they would on another type of preferred share. Given these factors, most companies prefer to issue non-retractable preferred shares. As a result, the retractable sector has declined significantly in size over the past decade, and represents only 13% of the conventional Canadian preferred share universe today. 22 Straight A Straight preferred share pays a fixed dividend and has a redemption feature. As redemption is not mandatory, this type of preferred share is considered to have a very long or perpetual term. Because longer-term securities are more sensitive to fluctuations in interest rates than short-term securities, investors who buy straight preferred shares must be prepared for relatively high price variability over time as market interest rates fluctuate. Chart 2 on the following page highlights the relatively high price volatility of a high-quality straight preferred share between March 2000 and March Straight preferred shares usually command a higher yield than other types of preferred shares primarily due to the potential for price volatility. While not as popular among investors, straight preferred shares are favoured by issuers for the following reasons: (1) issuers can lock in equity capital for long periods; (2) there is no requirement to repay the capital on a specific date; and (3) the shares are eligible as Tier 1 Capital.

5 Preferred Shares, An Introduction May Straight preferred shares are one of the largest segments of the preferred share market, representing approximately 40% of the conventional Canadian preferred share universe. Fixed-eset A Fixed-eset preferred share pays a dividend that is fixed for a specified period (usually five years) and then reset every five years thereafter. Most issues specify the reset rate at the time they are issued, as explained in the following example. Chart 2: Straight Preferred Price vs 30-Year Canada Bond Yield Bond Yield (%) Bond Yield Share Price Mar Sep Mar Sep Mar-10 Example: Bank of Montreal 6.50% Fixed- Date eset Preferred Share Series 21 was issued Source: in March The coupon rate was fixed at 6.50% ($1.625 per annum) for the initial five years. In May 2014, and every five years thereafter, the coupon rate is to be reset at the prevailing 5-year Government of Canada bond yield plus 458 basis points. In this case, 458 basis points is the pre-determined reset spread. Let s assume that the 5-year Government of Canada bond yield is 3.00% on the first reset date. The new coupon rate would be 7.58% (= 3.00% %). The new dividend would be $1.895 per annum. The coupon rate would be reset in this manner every five years as long as the shares remained outstanding Preferred Share Price ($) Issuers have the privilege to redeem the shares at par value rather than reset the coupon. The decision to reset the coupon or redeem the issue will depend on credit market conditions. Specifically, if an issuer could raise capital at a lower spread than the pre-determined reset spread, they would likely redeem the existing issue. If not, the coupon rate would be reset and the shares would remain in the market at least for the next five years. The risk for investors is that the coupon is reset at a level that is not competitive with prevailing credit spreads. In addition to a five-year reset feature, most fixed-reset preferred shares offer holders the privilege to exchange their shares for new floating-rate preferred shares. In our example, the quarterly dividend on the new series would be equal to the average 90-day Canada T-bill yield plus 4.58%. As the T-bill yield changed, so would the quarterly dividend, hence the term floating-rate. Like straight preferred shares, fixed-reset shares have a very long, potentially perpetual, term. However, the coupon reset feature is expected to lessen the impact of changes in interest rates, as it should help bring the coupon rate into line with prevailing rates every five years. Consequently, a fixed-reset preferred share is viewed as more defensive and, hence, less volatile than a straight preferred share. The yield on a fixed-reset issue is generally higher than on a retractable and lower than on a straight preferred share. The fixed-reset sector grew significantly after 2006, and the sector now makes up approximately 43% of the conventional Canadian preferred share universe.

6 6 Preferred Shares, An Introduction May 2010 Floating-ate A Floating-ate preferred share pays a dividend that is based on the Canadian prime rate. Depending on the issue, the dividend rate is usually between 50% and 100% of prime. Because its dividend is linked to the prime rate, a floatingrate preferred share will appreciate when rates are rising, or anticipated to rise, and depreciate during periods of falling rates, all else equal. The floating-rate sector is a small component of the Canadian preferred share market, representing only 4% of the universe. Factors That Affect Preferred Share Prices The key factors that affect secondary market prices for preferred shares are interest rates, credit markets and liquidity, as described below. Interest ates Every security that pays a fixed distribution is sensitive to interest rate movements to some degree. Preferred shares are no exception. Normally, we look for an inverse relationship between bond yields and preferred share prices, with longer-term issues experiencing the most extreme price movement. etractable issues, with their specified retraction date, fixed-resets, with the coupon reset feature, and floating-rate issues, with their variable dividends, are less sensitive to changes in market yields. Straight preferred shares, whose dividend is fixed for a potentially very long period, are the most interest sensitive. Credit Markets Credit market conditions are reflected in the yield differential (the credit spread ) between Government of Canada bonds and preferred shares. As with corporate debentures, investors are generally willing to accept a narrower credit spread during periods of economic prosperity, and demand a wider spread during periods of uncertainty. The most dramatic example of this was seen during the Credit Crisis. Chart 3: Pre-Tax Interest Equivalent Spread Straight Preferred Yield vs 30-year Canada Bond Yield Spread 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 23/06/98 23/02/00 23/10/01 23/06/03 23/02/05 23/10/06 23/06/08 23/02/10 The normal inverse relationship between Date Government of Canada bond yields and preferred share prices was severely impaired Source: during the crisis. As investors fled to the relative safety of Government of Canada bonds, yields plunged to historically low levels. At the same time, an aversion to corporate risk caused credit spreads to widen to unprecedented levels. As Chart 3 illustrates, the average spread on high-quality straight preferred shares over long-term Canada bond yields rose from approximately 200 basis points (adjusted for the dividend tax credit 2 ) to almost 800 basis points at the peak of the crisis. Post-crisis, spreads have receded to approximately 400 basis points, but have not returned to pre-crisis levels. 2 In the preferred share market, credit spreads are usually adjusted to reflect the impact of the dividend tax credit so that comparisons to bonds can be made easily. The adjusted spread is referred to as the pre-tax interest equivalent spread or bond equivalent spread.

7 Preferred Shares, An Introduction May Liquidity At $42 billion, the market capitalization of the preferred share market is relatively small. Issue sizes range from $100 million to $400 million (4 million to 16 million shares). How a particular issue trades in the secondary market will depend on its type, size and credit rating. At certain times, the relatively low liquidity in the sector can result in high price variability. Conclusion The preferred share market offers many opportunities. Individual and institutional investors alike are attracted to the quality, high yield and tax efficiency that preferred shares offer. Depending on their requirement for income and their risk tolerance, investors may find that placing preferred shares selectively in an income portfolio consisting of bonds and debentures can help enhance returns without adding undue risk. Similar to the corporate debt market, liquidity in the preferred share market is limited and investors must consider the creditworthiness of the issuer prior to making an investment decision. Appendix A High and low designations after a rating indicate a company s relative strength within the rating category. P-1 Preferred Shares rated P-1 are considered superior credit quality and are supported by strong earnings and balance sheet characteristics. P-1 ratings generally correspond with companies whose senior bonds are rated AAA or AA. P-2 Preferred shares rated P-2 are considered satisfactory credit quality. Protection of dividends and principal is still substantial, but earnings, the balance sheet and coverage ratios are not as strong as P-1 rated companies. Generally, P-2 ratings correspond with companies whose senior bonds are rated A. P-3 Preferred shares rated P-3 are considered adequate credit quality. While protection of dividends and principal is still considered acceptable, the issuing entity is more susceptible to adverse changes in financial and economic conditions, and there may be other adversities present that detract from debt protection. P-3 ratings normally correspond with companies whose senior bonds are rated in the higher end of the BBB category. P-4 Preferred shares rated P-4 are considered speculative, where the degree of protection afforded to dividends and principal is uncertain particularly during periods of economic adversity. Companies with preferred shares rated P-4 generally coincide with entities that have bond ratings ranging from the lower end of the BBB category through the BB category. P-5 Preferred shares rated P-5 are considered highly speculative and the ability of the entity to maintain timely dividend and principal payments in the future is highly uncertain. The P-5 rating typically coincides with companies with bond ratings of B or lower. Preferred shares rated P-5 often have characteristics that, if not remedied, may lead to default. D This category indicates preferred shares that are in arrears of paying either dividends or principal.

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