Recognizing that Canadian preferred shares are not like bonds will help you make better investing decisions

There are generally two types of stock issued by a company: common and preferred shares. Preferred stocks typically have no voting rights (unless a specified number of dividend payments have been missed). Instead, preferred shares are entitled to a fixed dividend payment that’s paid ahead of any common share dividends. In the event of company bankruptcy, preferred shareholders have a higher priority claim on company assets than common shareholders.

High-quality Canadian preferred shares are okay to hold in your portfolio, although we think that the best common shares can offer both high yields and growth prospects.

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Consider this anecdote on how the risk/reward profile of Canadian preferred shares may not be what you think

I recently ran into an acquaintance who told me he is troubled by the low rate of return he is earning on his fixed-return investments. To improve his return, he’s thinking about buying an investment product that invests in preferred shares. He explained he likes the idea because dividends on preferred shares provide a higher return than bond yields and are “almost as safe.”

His broker pointed out that some preferred shares also come with various special features that enhance their safety, or give the holder an option to get money out early, or get a higher yield if interest rates rise. The broker also said that returns of 8% to 9% are possible in this investment product.

To top it off, the investor told me he won’t have to pay a commission to buy this investment product, since he pays his broker a fixed fee for portfolio management.

Like a lot of investment products, this one could work out fine for investors if everything goes as planned. However, the buyer has to accept a lot of things on faith.

For instance, although you might say preferreds are “almost as safe” as bonds, you need to recognize that safety varies widely in the bond market, just as it does in any investment market. Then too, bond interest is generally guaranteed in one way or another, although the strength of the guarantee varies widely. In contrast, preferred dividends are not guaranteed. Companies only pay their preferred shares if they choose to do so.

The dividends are “preferred” in that they get paid before dividends on common shares. Sometimes, however, companies fail to pay dividends on preferred or common shares.

It’s misleading to describe the special features as “extras” or “sweeteners,” as brokers refer to them. Companies include them in the deal to make an offering of preferred shares palatable to investors. Experienced, successful investors are more likely to refer to the special features as “bells and whistles.” That’s because they exist to distract you so you overlook the negatives.

One key negative in this deal is the assumption that it may generate annual returns of 8% to 9%, roughly double the current dividend yields of preferred shares. To get yields that high in preferred shares, the manager of the preferred investment product would have to focus on one or both of a couple of high-risk tactics.

The investor who told me about this investment didn’t seem aware that preferred shares are a form of fixed-return investment. That means that prices of preferred shares are inversely correlated to interest rates. Simply put, this means that when interest rates go up, prices of fixed-return investments tend to drop.

All in all, we feel you should downplay or avoid preferred shares, regardless of whether you hold them directly, or through an investment product or fund. Preferreds offer higher current income than bonds or stocks, but they provide at best a false sense of security.

If you want income, you’re better off owning a diversified portfolio of high-quality, dividend-paying stocks. If that seems too risky for comfort, invest a portion of your portfolio in government bonds with maturities of two years or less. If interest rates go up, you can avoid losses on short-term bonds by holding them until they mature.

Use our three-part Successful Investor approach to make better stock picks, and build a top portfolio

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Do you hold any preferred shares in your portfolio? Do you find them to be risky or have they performed well for you?