Why the preferred-shares party might be winding down

Buying the preferred shares the big banks issued during the financial crisis is an example of those small, neat wins that conservative investors can parlay into solid gains over the years.

But now it's time to consider selling those rate-reset preferred shares and find alternatives. There may never be a better time, in fact.

The banks sold lots of rate-reset preferreds back in 2008 and 2009, as they scrambled to build up their financial base at a time when global markets seemed to be unravelling. The shares were issued at $25 and offered quarterly dividends yielding in the areas of 5 to 6.5 per cent.

Investors anxious to tap into that dividend flow have bid the shares up in price and they now commonly trade in the $26-to-$28 range. Good deal for those who got in early, right? You've got a high dividend yield, and share-price gains.

Here's the complication. Rate-reset preferreds were designed so that around about their fifth anniversary, the issuing bank will either redeem them at the issue price, also known as par, or reset the dividend rate so that it yields as much as 4.5 percentage points over the five-year Government of Canada bond yield. Financial types would describe this as a spread of 450 basis points, with 100 basis points being equal to one percentage point.

There are two reasons why bank rate resets will be redeemed at the earliest opportunity, argues James Hymas, president of Hymas Investment Management Inc. and a preferred share specialist. The first is that the dividend these shares must pay on reset is a reflection of a financial marketplace in crisis and not today's much calmer environment.

"Now, banks wouldn't have to pay more than 100 basis points over Government of Canada bonds," Mr. Hymas said. "Even some of the junkier issues [of rate-reset preferred shares]are coming out at a spread of 200 basis points."

The other reason why banks are expected to redeem their rate-reset preferreds and, in fact, other preferred-share issues as well, is a new set of global banking rules that will be gradually phased in ahead of a 2022 implementation date. The rules will not allow banks to include preferred shares in the key measure of their financial solidity.

Banks are expected to phase out their preferred-share holdings as a result, and this suggests almost all rate resets are going to be redeemed at the first opportunity.

Mr. Hymas said 2014 is when most bank-issued rate resets will hit their first reset/redemption date. Should investors get out now? "Those looking for a long-term investment can do much better elsewhere," Mr. Hymas said.

He suggests looking at bank and insurance company perpetual preferred shares. Generally, perpetuals have no fixed redemption date and offer no rate-reset potential. Really, they're a lot like open-ended bonds with no maturity date.

Mr. Hymas argues that most perpetuals issued by banks are a different animal because the 2022 regulatory deadline is almost like a drop-dead date for redemption. In fact, he regards them as being nearly as good as retractable preferred shares, which have a preset date for redemption.

Retractables are considered a desirable kind of preferred share because they offer an escape hatch that perpetuals lack.

The term "deemed retractable" has been coined by Mr. Hymas to describe bank perpetuals that he expects to be redeemed by 2022. An example of this type of share from his recommended list is Royal Bank of Canada Series AD, which have a dividend yield of about 4.6 per cent based on a share price of $24.37. If you hold until redemption at $25, your total return (share price gain plus dividends) is a littler bit higher.

There's some uncertainty right now about whether insurance companies will be bound by the same rules as banks on preferred shares. Mr. Hymas thinks they will be, and he therefore suggests insurance company perpetuals as another potential landing spot for people selling bank-issued rate resets.

An example from his recommended list is the Great-West Lifeco Inc. Series I, which have a current yield of 5 per cent based on a price of $22.46. In his May newsletter, Mr. Hymas projected the yield based on a $25 redemption in 2022 at 6.25 per cent.

Another money manager who sees benefits in selling bank rate resets now is Ric Palombi, fixed-income portfolio manager at McLean & Partners in Calgary. What to buy as a replacement? He suggests floating-rate preferred shares issued by BCE Inc.

Floating-rate preferreds have their dividends adjusted at regular intervals to reflect up or down moves in a reference interest rate, usually the prime rate at the major banks. This feature makes them the preferred-share world's answer for investors who are worried about rising interest rates.

"To me, it makes tremendous sense to swap [bank rate resets]for something like a BCE floater," Mr. Palombi said. "If by chance the Bank of Canada starts raising interest rates very aggressively in the next six to nine months, then I'm way ahead of the game."

BCE has several series of floating-rate preferred shares, but Mr. Palombi likes Series AH and Series Y, both of which have a current yield of 3.1 per cent. Both are paying 100 per cent of the prime rate. A non-financial floating-rate preferred share suggested by Mr. Palombi is Brookfield Asset Management's Series 8, which is also paying 100 per cent of prime and has a yield of 3.2 per cent.

Tempted to go for something with a higher yield? Yellow Media preferred shares currently have yields in the 4.7-to-10-per-cent range, a reflection of investor concern about the company's financial prospects.

Mr. Palombi is taking a pass on those shares because he thinks preferred shares should be owned to provide stable income, not to speculate. He reminds investors of what happened to people who bought Nortel Networks' preferreds to capture sky-high yields. Nortel kept up dividends on those shares for quite a while, but then suspended them on its way down the drain.

While floating-rate preferreds offer some protection against rising rates, perpetual preferreds are considered vulnerable. Mr. Hymas said they behave like long-term bonds when rates are rising, which means they could fall significantly in price.

He says investors considering perpetuals should ask themselves what's more important, a secure flow of income or a high degree of certainty that they will get their principal back on a set date. If they stress income over getting their money back on schedule, then perpetuals can make sense.

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There's an argument to be made for selling the rate reset preferred shares the big banks issued in the past few years and moving into other kinds of preferred shares. Here are some preferred share options suggested by a pair of money managers.

James Hymas, president of Hymas Investment Management Inc.

He suggests bank and insurance company perpetual preferreds that he expects to be redeemed by 2022 as a result of new global financial industry rules:

Ric Palombi, fixed income portfolio manager at McLean & Partners in Calgary

He highlights these floating-rate preferred shares:

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Preferred Share ABCs

What are they: Shares that are primarily held to generate tax-advantaged dividend income.

Advantages: Dividends on preferred shares rank ahead of those paid on common shares when a company runs into financial trouble; less volatile than common shares, but they did fall hard in 2008

Risk: Like bonds, preferred shares fall in price when rates rise and move higher when rates fall; they are also vulnerable to declines in the financial health of the issuing company

DIY Investors: Companies provide details on their preferred shares in the investor relations area of their websites; also try prefinfo.com

Kinds of Preferred Shares:

Floating Rate: The dividend typically floats in relation to the prime lending rate at major financial institutions; may be redeemed at the issuer's option.

Perpetuals: Have no fixed maturity date, but can be redeemed at the option of the issuer; they pay a fixed dividend.

Rate Reset: The issuer will at set intervals either redeem the shares or reset the dividend to reflect up or down moves in interest rates.

Retractable: Have a fixed maturity date