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Preferred Shares

ROB CARRICK

You like predictions? Okay, here's one -- 2007 will be the year of the preferred share.

Most investors will be oblivious to this phenomenon, and there will be little or no media coverage because preferreds are a black hole of dullness in the financial world. And yet, investors looking for a safe source of income and a better yield than bonds or guaranteed investment certificates offer are going to flock to preferreds this year. That's my prediction, anyway.

Think of a preferred share as a sort of safety stock. You'll get a dividend as a preferred shareholder, and it's very secure because a company in trouble will pay you ahead of common shareholders. The catch is that preferred shares are basically inert. They do move up and down in price, but not nearly as much as the common shares.

Already in 2007, there's a bit of a buzz in the preferred share market. Earlier this month, $600-million worth of preferred shares were issued by two of the big banks, Royal Bank of Canada and Bank of Montreal. Inquiries from readers of this column about preferreds have gone from one per year to a couple per week. Some money managers have also noted an increasing interest.

"We've been heavily investing in these for the past eight or so months, but I'm getting a real sense from the trading desks that I talk to that we're starting to see a really robust retail market," said Ric Palombi, a portfolio manager with McLean & Partners Wealth Management in Calgary.

James Hymas, a money manager and one of the country's foremost experts on preferred shares, hasn't seen much of a pop in the market lately. "But the amount of pondering that's going on has certainly increased," he added. "I would think that will probably translate into buying in the near future."

There are two reasons for the increased interest in preferred shares, one of them being the enhancement in the dividend tax credit that was introduced by the previous Liberal government and left alone by the Conservatives. The other reason is the decline in the attractiveness of income trusts as a result of recent actions by Ottawa.

If you're an income-oriented investor and you've crossed trusts off your list of things to buy, then dividend stocks of all types are a good option. Preferreds, on average, provide higher yields than common shares, and these yields look even better on an after-tax basis.

The RBC and BMO preferred shares issued earlier in January were priced to yield 4.5 per cent, which is a bit better than a government bond or GIC but not impressive when viewed against income trust yields. If you own preferreds in a registered account, that's the end of the story. But if you own them in a taxable account, your net returns in preferred shares may surprise and delight you.

Mr. Hymas, president of Hymas Investment Management, said an Ontario resident would need a bond yielding 6.3 per cent to get the same after-tax return as bank preferred shares yielding 4.5 per cent. "Getting 6.3 per cent from a bank is something people haven't been able to do in quite some time."

Bonds, of course, are a more secure form of income than preferred shares. Remember how preferred shareholders get their dividends ahead of common shareholders? Well, bondholders get their interest before preferred shareholders get paid. Still, Mr. Hymas thinks preferred shares are solid as long as you stick to those that are investment grade. That means a rating from Dominion Bond Rating Agency of pfd-2 (low), which would be considered investment grade or good enough for pension funds.

Mr. Hymas believes the safety of investment-grade preferreds means they can be used almost interchangeably with bonds. "I have no hesitation in recommending that preferred shares should be up to half of the fixed-income component of an individual's portfolio."

While top-quality preferreds deliver yields in the vicinity of 4.5 per cent, it's possible to get higher returns if you're willing to accept the risk of lower-rated issues. For example, there are preferreds issued by Quebecor World yielding about 9.7 per cent, while Nortel Networks, Bombardier and Domtar have issues yielding in the 7- to 8-per-cent range. Mr. Hymas himself doesn't follow preferred shares like these, and he regards them as being much closer to common stocks than the bonds that high-grade preferreds resemble.

Both Mr. Hymas and Mr. Palombi see more companies issuing preferred shares in the year ahead, partly because of strong demand from investors but also because there are advantages to raising capital with preferreds as opposed to bonds or common shares. How do investors find the right preferred shares? It's not easy, but we'll look at some resources in a follow-up column in the next week or so.



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