preferred shares

Preferred shares can add another source of income and diversification to the portfolios you manage for your clients. They represent ownership in a company, but they also offer dividend terms that resemble bond interest. They also sit behind creditors but ahead of common shareholders when it comes to claims on dividends and assets.

When you understand these features, you can decide when preferred shares support your clients' income needs, tax situation, and risk profile. In this article, Wealth Professional Canada will shed light on preferred shares and other valuable insights. We've also included all our published news stories on preferred shares below, so feel free to check them out!

What are preferred shares?

Preferred shares, sometimes called preferred stock, are a class of equity that gives your clients partial ownership of a company. Along with common shares and retained earnings, they form part of shareholder equity. They also reflect the money that business owners and other investors have paid into the business.

Preferred shares trade on stock exchanges in the same way as common shares. Your clients can buy them through their usual online brokerage accounts on markets such as the Toronto Stock Exchange (TSX). Watch this video for more on preferred shares:

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If you want to become a top-performing financial advisor in today's market, you need to master how preferred shares work.

Priority for dividends and assets

Companies issue preferred shares with specific terms of payment. Those payments come in the form of dividends. The dividend rate is usually set when the shares are issued and is often higher than the dividend yield on the same company's common stock.

In this way, preferred shares sit between stocks and bonds. They can appreciate in price over time like common stock, yet they also provide a more predictable stream of income.

Preferred shareholders have priority over common shareholders when dividends are paid. When a company declares dividends, preferred shareholders are next in line after creditors and bondholders. Common shareholders receive dividends only after the company has met its obligations to preferred shareholders.

Preferred shares are still unsecured equity. Dividend payments are not a legal requirement until they are declared by the company. If conditions are difficult, management can decide to suspend dividends.

In structures where dividends are cumulative, any missed amounts build up and must be paid before common share dividends resume.

Limited or no voting rights

One of the most visible differences between preferred and common shares is voting power. Common shareholders often receive one vote for each share they own and can vote for board members and on major policy decisions. Preferred shareholders usually do not have voting rights.

From the company's perspective, preferred shares are a way to raise capital without diluting control. Founders or other groups can hold voting shares, while institutions and individual investors buy preferred shares for income and prioritize distributions.

How are preferred shares taxed in Canada?

Tax treatment can influence which securities you recommend for each type of account. Preferred shares that pay eligible Canadian dividends can qualify for the federal dividend tax credit.

This means that the income your clients receive from preferred shares is often taxed at a lower rate than the interest they receive from bonds in a non-registered account.

As such, preferred shares can be more tax efficient than bonds when held in taxable accounts. Your clients still get recurring income, yet the tax burden is lighter compared with fully taxable interest.

Over a long period, the difference in after tax income can be meaningful, especially for households in higher tax brackets.

From a tax perspective, interest income is usually better suited to registered plans such as Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). Inside those accounts, interest does not create an immediate tax liability. This helps preserve more of the return from conservative holdings.

You can often improve the overall tax outcome by pairing preferred shares and bonds with the right account types. Non-registered accounts can hold preferred shares that pay eligible Canadian dividends.

Registered accounts can focus more on bond holdings that generate interest. With this approach, you can help your clients keep more of what their portfolios earn without changing the underlying risk level.

Why do people buy preferred shares?

Your clients are drawn to preferred shares for several reasons. As a financial advisor, you can use these motivations to decide when preferred shares belong in a portfolio and how large that position should be.

Here are four reasons why investors buy preferred shares:

• stable and higher income
• diversification benefits
• alignment with risk tolerance
• access and practicality

Let's discuss them further below:

1. Stable and higher income

The first reason is income stability. Preferred shares usually pay fixed dividends at regular intervals. This gives your clients a more predictable cash flow than variable common share dividends. When markets are unsettled, a known dividend rate can provide reassurance and support ongoing spending needs.

Preferred share dividends are often higher than the dividends paid on common shares of the same issuer. They can also exceed the yields on that issuer's bonds.

For income-focused investors, this higher payout can be attractive. Your clients should be aware that preferred shares sit behind bonds in the payout order. In exchange, they receive greater income and some opportunities for capital gains.

2. Diversification benefits

Preferred shares can also help diversify a portfolio. They behave differently from common shares and traditional bonds, since they combine features of both.

They are sensitive to changes in:

• interest rates
• credit conditions
• the company's health

At the same time, they tend to have a low correlation with stocks and bonds. This means that preferred shares might react differently to changing market conditions than other holdings in your clients' portfolios.

For example, a portfolio built only from common shares might move closely with equity markets. A blend that includes preferred shares can soften some of these swings. This is because preferred prices respond to other influences, such as rate movements and shifts in dividend expectations.

3. Alignment with risk tolerance

Preferred shares also appeal to clients who want something between the relative safety of bonds and the greater volatility of common stock. Because preferred investors stand ahead of common shareholders in the capital structure, they have a higher claim on dividends and assets.

However, they still carry more risk than bondholders, who receive interest before any dividends are considered. This position in the structure is suitable for clients who are comfortable with some credit and market risk. But it might not be appropriate for those unwilling to accept the full volatility associated with common equity.

4. Access and practicality

Your clients can buy preferred shares on the same platforms they already use for common stock. Many issues are purchased in bulk by institutions when they are first offered, but individual investors can still access them in the secondary market.

As with any individual security, concentration risk is a concern. If your clients buy preferred shares from only one or two companies, they are exposed to the fortunes of those issuers.

To gain better diversification with preferred shares, your clients need exposure across various companies and industries. That might be challenging for small accounts that rely only on single issues.

You can address this by watching the size of preferred positions relative to the total portfolio and by spreading preferred exposure where possible.

What's the difference between preferred and common shares?

Common and preferred shares both represent ownership in a company. They mostly differ in the rights they grant and the way they pay income. They also vary in the position they occupy in the payout order.

When you explain these differences to your clients, you can help them see why a mix of both might suit their goals. Check out this video for more:

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Ownership and voting power

Holders of both common and preferred shares own a slice of the company. The distinction lies in control. Common shareholders usually receive voting rights that increase with the number of shares they hold. They can vote on board appointments and other important corporate issues.

Preferred shareholders generally do not have voting rights. They accept limited influence over the direction of the company. In return, they receive stronger claims on income and assets.

This trade off lets companies raise capital while keeping control concentrated among specific groups who hold voting shares.

Claims on earnings and assets

When a company earns income or faces liquidation, there is an order in which different stakeholders are paid. Bondholders and other creditors come first, since they hold debt claims. Preferred shareholders are next. Common shareholders are at the end of the line.

In a going concern, this order affects dividend decisions. Management must consider obligations to creditors and preferred shareholders before it allocates dividends to common shareholders.

In a failure, it affects who gets what from any remaining assets. Preferred shareholders stand ahead of common shareholders, so they have a better chance of recovering some value.

This hierarchy explains why preferred shares are often viewed as less risky than common shares but riskier than bonds. Your clients' position is less secure than that of bondholders, but they receive higher income and structural advantages over common shareholders.

Helping your clients benefit from preferred shares

Preferred shares give you another way to support your clients' investment goals. They offer higher priority than common shares for dividends and assets and more favourable tax treatment in non-registered accounts than fully taxable bond interest.

When you discuss preferred shares with your clients, start with their objectives and risk tolerance. Explain where preferred shares sit in the capital structure and how their dividends work.

Help your clients understand that concentrating preferred holdings in only one or two issuers increases risk. Show them that diversification across companies and industries strengthens the role of preferred shares in your clients' portfolios.

When you add preferred shares to your planning, your clients gain another source of income and stability while still owning part of the companies they invest in.

Discover the latest news on preferred shares below!