Preferred Share

Halfway between a stock and a bond

A preferred share sits between the common share and the bond in a company's capital structure, and it borrows traits from both. Like a bond, it pays a fixed income: the dividend rate is set when the shares are issued, and in Canada preferreds are typically issued at a par value of $25 per share. Like a stock, that payment is a dividend rather than interest, and the share has no maturity date.

The "preferred" part is a queue position, twice over. The company must pay the preferred dividend in full before it pays any dividend on its common shares, and in a liquidation, preferred holders are repaid before common holders, though still after every creditor and bondholder. In exchange, preferred shareholders usually get no vote and almost none of the upside: if the company triples in value, the common shares triple and the preferreds mostly just keep paying their fixed dividend.

The types: perpetuals and rate-resets

A perpetual preferred pays the same fixed dividend forever, or until the issuer redeems it. With no maturity date, its price behaves like a very long bond: highly sensitive to long-term interest rates, rising when they fall and falling when they rise.

The distinctly Canadian structure is the rate-reset preferred, and it dominates the Canadian preferred market. Its dividend is not fixed forever: every five years, the rate resets to a spread over the 5-year Government of Canada bond yield that was fixed at issue. On each reset date, holders can typically choose between another five-year fixed rate or a floating-rate version, and the issuer gains the right to redeem at par.

An honest word on how rate-resets behave. The reset feature cuts both ways. When government yields rise, upcoming resets promise bigger dividends, which supports prices. When yields fall, the same mechanism grinds the other way: each reset locks in a smaller dividend, and prices can drop hard, which surprised many investors who had bought rate-resets as a conservative income substitute. These are not fixed-income tranquillity; they are a leveraged opinion on where 5-year yields are heading, wrapped in a dividend.

Why companies issue them, and who buys them

For the issuer, preferred shares raise capital without diluting the ownership and control of common shareholders, and without adding debt that could strain credit ratings. For banks and insurers, which are the largest Canadian issuers, preferred shares also tend to count favourably in the capital that regulators require them to hold, which is a quiet but important reason the Canadian market is so bank-heavy.

The buyers are mostly income seekers holding taxable accounts. Preferred dividends from Canadian public companies are generally eligible dividends, which benefit from the dividend tax credit, so a preferred's dividend can leave more after tax than bond interest at the same headline rate. That tax edge is the core of the pitch, and it is real; the risks around it are covered next.

The risks

Preferred shares are often sold on their steady income, but the price of that income is a specific bundle of risks:

• Interest-rate sensitivity. Perpetuals fall when long yields rise; rate-resets fall when 5-year yields drop. Either way, rates drive prices, and swings of 20% or more over a cycle are not unusual.
• Extension risk. The issuer redeems only when it suits them. A preferred you expected to be called at $25 can instead sit outstanding through reset after reset, paying a diminished dividend while you wait.
• Thin liquidity. Individual preferred issues are small and trade lightly, so bid-ask spreads are wide and selling in a stressed market can mean accepting an ugly price.
• Redemption at par. When rates move in your favour and a preferred trades above $25, the issuer can often call it back at par, capping your upside precisely when things are going well.

Preferred shares vs. bonds

The comparison worth keeping straight: a bond's interest is a legal obligation, and missing a payment is a default; a preferred dividend can be suspended without triggering one, though the issuer must then also stop paying common dividends, which real companies avoid at almost any cost. Bonds mature and return their face value on a known date; most preferreds never mature, so there is no date when your capital is promised back. And bonds rank ahead of preferreds in an insolvency. A preferred share is therefore riskier than the same company's bonds, and it compensates with a higher yield and better tax treatment. Whether that trade is worth it depends on your tax rate and your tolerance for price swings, not on the word "preferred".