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What do you think of preferred shares? Is this a good time to buy them?

Preferred shares stake out the middle ground in a company's capital structure, ranking ahead of common shares but behind bonds. This has advantages and disadvantages for the investor.

On the plus side, if a company needs cash, it will cut common dividends before it touches preferred dividends. If the company goes bust, preferred shareholders are second in line to bondholders for any assets of the business.

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Another advantage of preferred shares is that their dividends qualify for the dividend tax credit, making them suitable for taxable accounts. And because preferreds generally pay a fixed dividend, they are less volatile than common shares.

On the down side, because preferreds are only entitled to a fixed portion of the profits, they offer less capital appreciation potential than common shares. Preferreds also come in various flavours – perpetual, retractable, rate-reset and floating rate – that may be confusing to some retail investors. (For more on rate-reset preferreds, see my column here.) Finally, because of their bond-like characteristics, preferred shares tend to be sensitive to interest rates.

Keeping those risks in mind, devoting a portion of your fixed-income allocation to preferred shares can provide a steady source of tax-efficient cash flow. And because preferred shares have taken a hit recently with the uptick in interest rates, yields are higher now than they were just a few months ago.

Since April 1, the iShares S&P/TSX Canadian Preferred Share Index Fund (CPD) has dropped about 6.6 per cent, excluding dividends. The fund is now yielding about 4.5 per cent, up from 4.2 per cent on April 1.

If you're uncomfortable picking individual preferred shares, a diversified exchange-traded fund such as CPD can be a good option. The fund, which has about $1.4-billion under management, holds more than 200 preferred shares, with banks and insurance companies accounting for more than half of the assets. The fund has a management expense ratio (MER) of 0.5 per cent.

Portfolio managers say it's important not to go overboard with preferreds.

"We use them as one piece of the puzzle," said Adrian Mastracci, president and portfolio manager with KCM Wealth Management in Vancouver. He uses CPD and other preferred ETFs in client portfolios, but limits preferreds to about one-quarter of the client's fixed-income exposure.

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Despite their defensive characteristics, preferred shares won't necessarily save you in the event of another financial crisis. During the credit meltdown in 2007-08, CPD plunged more than 30 per cent from peak to trough. The fund did, however, continue paying dividends, and the units eventually rebounded, though not to pre-crisis levels.

Another option is the Horizons Active Preferred Share ETF (HPR), which – as the name suggests – is run by a manager who actively buys and sells preferred shares, as opposed to passively tracking an index as CPD does. HPR's unit price has also dropped with the recent jump in interest rates. Its yield of 4.3 per cent and MER of 0.58 per cent are similar to CPD's.

Bank of Montreal has also thrown its hat into the preferred share ring with the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR). Launched last year, ZPR yields about 4.5 per cent and has an MER of 0.49 per cent.

Whether you go with individual preferred shares or choose an ETF such as CPD, HPR or ZPR, it's important to remember that preferred shares are not going to deliver the sort of long-term gains you can expect from common shares of growing, profitable businesses.

What they will give you is a source of stable dividends that are taxed more favourably than the income from bonds or guaranteed investment certificates.

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