Friday, April 16, 2010

My Take of Preferred Shares

Fixed Income instruments are an important part of a portfolio. however holding bonds in a non registered account is a bad idea.  It is also a bad idea to be 100% invested in equities. This is where preferred shares can fill a void.

Most Canadian Preferred shares pay an eligible dividend unlike bonds which pay interest income you get to take home more of your money and stop the government from reallocating it to seniors and welfare drug junkies.

Preferred shares add a new asset class to your portfolio, therefore reducing volatility ( though as a dividend investor volatility shouldn't bother you too much ), provide dividend income that is even more reliable than common share dividends, provide more security to your principal investment and depending on the type of preferred share usually offer higher dividends than common shares.

Now all these are great points, but what’s the catch? We all know there is no free lunch. The catch here is that you are forgoing any capital appreciation. Yes they are shares, but in reality they are fixed income instruments. Your dividends do not increase, and the share price does not significantly increase / decrease.

Preferred shares also expose your portfolio to interest rate risk, similar to bonds. If rates rise, these fixed dividend paying non appreciating shares, There value will drop with higher interest and rise with lower interest.

Preferred shares come in different shapes and sizes I'm not going to go over it here. But Google "guide to preferred shares" for a good pdf from Scotia bank that explains preferreds and provides some commentary.

50% of the Dividend Lover non registered portfolio is in preferred shares. But do as I say not as I do. Depending on your age and risk tolerance treat preferred shares as you would fixed income instruments to come up with the right asset mix.

My allocation in Preferreds in outsized making the portfolio more conservative because I do not own any other fixed income instruments anywhere else, and because I am using excessive leverage, therefore must lower the risk in the portfolio to balance the risk added by leverage.

Now you might be thinking that intrest rates are rising why would I buy these preferred shares?  well Prepetual Preferred shares follow the 30 year government of canada bond interest rate + some kind of premium related to the issuer and other details. Changes in the short term interest rate is tempered because of the shape yield curve and long term interest rate. That and the expectation of higher interest rates down the road are already factored into the price. Your not the first person to figure out rates are rising.

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