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Are these preferreds a 5-per-cent solution?

Five-per-cent dividend yields are plentiful today in a mostly overlooked corner of the preferred-share market.

Perpetual preferred shares are a classic risk-reward case study for investors. The yields are juicy in today's low-rate world, and reliable where blue-chip companies are the issuer. The bulk of the preferred-share market today is made up of rate resets, which all have their own formulas for setting payouts in relation to five-year Government of Canada bond yields. With a perpetual, the yield is the yield.

But don't lock your radar on perpetuals just yet if you're after steady investment income that beats bonds and guaranteed investment certificates. If speculation this week about higher interest rates ahead proves accurate, then perpetuals would be at risk of a sharp drop in price. In a few cases, the price of these shares was already edging a tiny bit lower at midweek.

Perpetual preferred shares pay a fixed dividend perpetually, or at least until the issuer uses its option to redeem them. Think of them as being something similar to long-term corporate bonds with no firm maturity date and less security. A troubled company would suspend common-share dividends before addressing preferred shares, and cut preferred dividends before suspending interest payments on bonds.

For portfolio manager Phil Mesman of Picton Mahoney Asset Management, the open-ended nature of perpetuals is a deal-killer. "As a former banker guy, the idea of lending a company money at 5 per cent forever is unacceptable," he said. "I don't believe there is good value in perpetuals."

IncomeResearch.ca's Harry Levant focuses on the dependable flow of tax-advantaged dividend income. "I kind of look at these from a retired person's point of view – someone who maybe wishes they had a defined benefit plan but has to manage their own stuff," he said. "These shares are well-suited for retirement portfolios."

At the beginning of this decade, perpetuals accounted for 104 of the 225 preferred shares covered by Mr. Levant. Today, they represent just 103 out of the 365 share issues he follows. Rate resets have proliferated at the expense of perpetuals because of concerns about rising rates. If you think we'll see steadily higher interest rates in the years ahead, a rate reset offers a degree of protection by having its dividend yield reset every five years to maintain a preset premium over five-year Canada bonds.

And yet, there's still some demand for perpetuals from both retail and institutional investors. Three companies in the insurance business, Great-West Lifeco Inc., Intact Financial Corp. and Power Financial Corp., issued perpetuals last month with yields above 5 per cent. Each of the three shares has recently traded just above the $25 issue price.

The future path of interest rates will determine what happens to perpetuals from here. Recent comments from the Bank of Canada seem calibrated to prepare the country for rate hikes that could start as soon as this fall. But we've seen speculation about rate hikes flare up a few times in recent years and then fade out.

In fact, the general trend for rates in the past 10 years has been downward. That's why rate reset preferred shares were smashed in 2015 (they've since rebounded somewhat). Their yields can be adjusted higher when rates rise, and lower when rates decline. Perpetuals, with their steady dividends, fell only a little as rate resets plunged.

James Hymas, president of Hymas Investment Management and a preferred-share specialist, said there are roughly a dozen blue-chip perpetual issues that combine a straightforward structure with a share price below their $25 issue price. These shares, issued by Brookfield Asset Management, Canadian Utilities, E-L Financial, Power Corp. of Canada and Power Financial, had an average yield of 5.1 per cent as of earlier this week.

Mr. Hymas said perpetuals could be an attractive option for investors who are looking at long-term corporate bonds, which mature in 10 years or more. These bonds have a yield of roughly 3.6 per cent on average today compared with perpetuals in the range of 5 per cent.

You'd need about 6.6 per cent from a bond to give you the same after-tax yield as a perpetual preferred share. Multiply a dividend yield by 1.3 to get the rough equivalent from a bond after paying taxes, Mr. Hymas said.

The drawback with perpetuals is that they are highly sensitive to rising interest rates. Mr. Hymas sees five-year Government of Canada bonds eventually rising from current levels just above 1 per cent to the 3-per-cent to 3.5-per-cent range. If that happens, expect perpetuals to plunge in price. "It could be quite traumatic," he said.

Much less of a concern is the security of the dividends paid by perpetuals. The dozen perpetuals highlighted by Mr. Hymas are all rated Pfd-2 by the rating agency DBRS, which means satisfactory credit quality. Pfd-1 is superior quality, while Pfd-5 is highly speculative.

Companies that issue perpetuals have an option to redeem the shares based on terms set out in the prospectus (you can find prospectuses on Sedar.com). While you shouldn't buy these shares based on the potential for a future redemption at the $25 issue price, there are some perpetuals that might actually be in line for this at some point in the next several years.

Mr. Hymas believes that regulations covering the banking sector and its capital structure could, in the next few years, be applied to life insurance companies. Some preferred shares would then become disadvantageous for insurers and, in turn, be candidates for redemption in the years ahead. A redemption would turn a perpetual preferred share into a maturing investment similar to a bond.

Mr. Hymas said he likes three issues of insurance-company perpetuals with redemption potential: Sun Life Financial Series 5 (SLF.PR.E), Manulife Financial Series 3 (MFC.PR.C) and Great-West Lifeco Series I (GWO.PR.I). All have yields at or just below 5 per cent based on recent share prices and dividends. If the shares were redeemed in the next eight to 12 years at $25, that yield would work out to be a bit higher (the shares all currently trade below $25).

These preferred shares pay 5 per cent

Perpetual preferred shares from blue-chip companies pay a steady dividend – there are no rate resets in the future and no set redemption date. Preferred share specialist James Hymas highlighted these perpetuals on the basis that they are trading at their issue price of $25 or below, have an uncomplicated structure and and offer a yield of 5 per cent or slightly more. These shares could be in for a rough ride if interest rates rise, but the dividend would be unaffected as long as the issuing company remains financially healthy.

IssuerTSX tickerDividendRecent share price Yield based on recent share price (%)DBRS ratingYTD price chg (%)One-week chg (%)
Brookfield Asset Mgt.BAM.PF.C$1.21 $23.20 5.2Pfd-2 (low)6.9-1
Brookfield Asset Mgt.BAM.PF.D$1.23 $23.63 5.2Pfd-2 (low)7.3-0.4
Brookfield Asset Mgt.BAM.PR.M$1.19 $22.79 5.2Pfd-2 (low)6.90.2
Brookfield Asset Mgt.BAM.PR.N$1.19 $22.82 5.2Pfd-2 (low)7.3-0.3
Canadian UtilitiesCU.PR.D$1.23 $24.60 5Pfd-2 (high)5.50
Canadian UtilitiesCU.PR.E$1.23 $24.60 5Pfd-2 (high)5.2-0.2
Canadian UtilitiesCU.PR.F$1.13 $22.63 5Pfd-2 (high)5.30.4
Canadian UtilitiesCU.PR.G$1.13 $22.68 5Pfd-2 (high)6.10.4
E-L Financial ELF.PR.G$1.19 $23.19 5.1Not rated7.30
Power Corp.POW.PR.D$1.25 $25 5Pfd-28.2-0.1
Power FinancialPWF.PR.K$1.24 $24.29 5.1Pfd-2 (high)4.8-0.4
Power FinancialPWF.PR.S$1.20 $24.10 5Pfd-2 (high)7.90.2

Source: James Hymas, president of Hymas Investment Management Inc.

Another perspective

These perpetual preferreds are recommended for income-seeking investors by analyst Harry Levant of IncomeResearch.ca

IssuerTSX tickerDividendRecent share price Yield based on recent share price (%)DBRS ratingYTD price chg (%)One-week chg (%)
Fortis Inc.FTS.PR.J$1.19 $23.76 5Pfd-3 (high)4.1-0.2
Great-West LifecoGWO.PR.I$1.13 $22.75 5Pfd-2 (high)5.30.5
Sun Life FinancialSLF.PR.A$1.19 $23.95 5Pfd-2 5.1-0.1
Manulife FinancialMFC.PR.B$1.16 $23.59 4.9Pfd-2 5.81
Power FinancialPWF.PR.S$1.20 $24.10 5Pfd-2 (high)7.90.2
Canadian Utilities CU.PR.G$1.13 $22.68 5Pfd-2 (high)6.10.4

Source: Harry Levant, IncomeResearch.ca

Notes for both charts: Share price data is to June 14; DBRS is a rating service; yield numbers shown assume the shares pay out indefinitely and are not redeemed at the issuer's option.

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