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Tax changes make dividend-paying preferred shares more attractive

by Wayne Cheveldayoff, 2006-08-17

The reduction in the tax rate on dividends has boosted the attractiveness of preferred shares, which usually pay dividends quarterly.

Preferred shares now provide higher after-tax returns than high-quality corporate bonds and should definitely be considered for inclusion in taxable portfolios, especially where the investor is seeking to maximize after-tax income, says James Hymas, a preferred share specialist.

The higher return, however, doesn’t come without risk. Technically, for any company, bonds rank ahead of preferred shares. If the company runs into serious financial trouble, bond holders would be paid off first before any money flows to preferred share holders. At the same time, however, preferred shares rank ahead of common shares, and if the trouble is temporary, a company would probably suspend its common share dividends before ceasing preferred share dividends.

Mr. Hymas, president of Hymas Investment Management Inc., has focused his research and investment attention on the preferred share market because he believes it offers better opportunities to safely invest for income than not only bonds but also the income trust market.

“The term ‘income trust’ is a misnomer, as they are small and medium-cap equities which blow up with alarming regularity and will continue to do so,” he says.

In contrast, preferred shares issued by large companies and financial institutions pose much less risk.

An example would be the issuance in mid-July by Power Financial Corporation, a major and very profitable Canadian financial conglomerate, of a 5.1 per cent Non-Cumulative First Preferred Shares, Series L, which Mr. Hymas found very attractive. The issue ‘flew off the shelf’, which Mr. Hymas believes shows “there is huge demand among investors for preferred shares.”

The dividends from the Power Financial preferred shares are taxed at a much lower rate than bond interest. Federal tax changes, which were matched by Ontario in early August and likely will be by all provinces, put the highest tax rate for dividends at around 21 per cent (down from 31 per cent), versus about 46 per cent on regular income, including bond interest.

In order to match the after-tax return on preferred shares paying 5.1 per cent, bonds from a similar, high-quality issuer would have to be yielding 7.5 per cent.

However, this isn’t the case. A quick check of high quality corporate bonds shows none yielding even as much as 6 per cent. Yields to maturity recently were 4.59 per cent for a 5-year Manulife Financial bond, 4.62 for a five-year Royal Bank bond, and 4.78 for a five-year Bell Canada bond. Longer-term high-quality corporate bonds were in the 5-per-cent range.

Mr. Hymas’ research shows that even under the less-favourable tax regime for dividends from 1994 to 2003, preferred shares on an after-tax basis performed better – 4.05 per cent annualized after-tax return for preferreds versus 3.55 per cent for the Scotia Capital Corporate Bond Total Return Index.

Not all preferred shares are as attractive as the Power Financial 5.1-per-cent issue. Just a few days prior to its announcement, Mr. Hymas issued a news release warning investors that the Royal Bank of Canada 4.7-per-cent Non-Cumulative First Preferred Shares Series AB being issued July 12 was “over-priced” and investors should look elsewhere. The $300 million Royal Bank issue carried a “liquidity premium” for being available in large quantities for institutional investors.

On the same day, he says, investors could have obtained more yield from similar preferred shares already trading on the TSX -- 4.94 per cent from a Power Financial preferred share, 4.95 per cent from a TransCanada Pipeline preferred share, and 4.87 per cent from a Sun Life preferred shares.

Mr. Hymas believes he is the only investment specialist in Canada focused exclusively on preferred shares. He offers a $500-per-month service (www.prefshares.com) to investment dealers and fund managers tracking and comparing prices for a universe of over 160 preferred shares on a daily basis.

Such as service is valuable because preferreds can be very complicated as many have call and put features and other special characteristics. He is planning a $30-per-month service for individual investors around year-end and in the meantime offers issue details (though not pricing comparisons) on many preferreds on a free website (www.prefinfo.com). Through his investment company, he also manages preferred-share portfolios for customers on a fee basis.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.



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©2006 Wayne Cheveldayoff