Ask MoneySense: Preferred shares

Bond interest is fully taxable, while the fixed dividends from Canadian preferred shares are taxed at a much lower rate.

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From the November 2012 issue of the magazine.

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AskMoneySense_322
I’m frustrated with the returns from my cash investments and looking for an alternative without raising my risk. Preferred shares seem like a good option, but my adviser says they don’t belong in my RRSP because I’ll lose the dividend tax credit. Am I correct or is my adviser?

Barry Walsh, Toronto

“There’s no harm in having preferred shares in an RRSP,” says TriDelta’s Ted Rechtshaffen. The tax credit shouldn’t be driving your investment decisions. If you’re considering a preferred share yielding 5% versus a bond that pays 4% with the same level of risk, then you should go with the preferred share, he says. But if you hold bonds in a non-registered account and preferreds in your RRSP “that’s just dumb,” he quips, because bond interest is fully taxable, while the fixed dividends from Canadian preferred shares are taxed at a much lower rate.

But Kerr Financial’s Ted Karon wonders whether preferred shares belong in your long-term portfolio at all. If rates go up perpetual preferreds—which act like long-term bonds and make up most of the preferred share market—will lose value. “Why buy a preferred instead of the common stock if you can get the same yield?” With common shares you can also benefit from price appreciation, he says, whereas preferreds rise in value only if interest rates decline. If you really want to buy preferred shares, Karon recommends variable or “step-up” preferreds, since the yields on these investments will fluctuate with interest rates.

Got a question about your finances? Email us at: ask@moneysense.ca

3 comments on “Ask MoneySense: Preferred shares

  1. What about holding the bonds or shares inside a TFSA? The interest wouldn't be taxable.

    Reply

  2. Very good counterpoint. This proves that you should always seek multiple perspectives even when receiving advice from a professional. Only then can you make the most informed decision.

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  3. Three different issues:
    1) The question of "Which assets should be held in taxable vs tax-shelter accounts" assumes you have already maxed out your RRSP and TFSA, and have assets in taxable accounts. The allocation of asset-types between the three accounts is decided by the $tax that would be paid in a taxable account. This is the equation = (Rate%of Return of investment) multiplied by (The tax rate at your personal tax bracket for that asset class).

    You put the assets with the highest $tax in RRSP and TFSA. You get the tax rate from http://www.retailinvestor.org/Taxburden.xls For an example showing how a top-tax-bracket person may be better with dividends inside an RRSP is shown at http://www.retailinvestor.org/RRSPmodel.html#taxf… . But the reverse would hold at the bottom tax bracket.

    2) The question of "Should you put assets into RRSP is you have room" is determined by the tax rate applied to the contribution vs the withdrawal. A difference in rates creates a benefit or penalty equal to the rate difference multiplied by the amount eventually withdrawn. But most often the benefit that everyone gets (= the shelter from tax on growth above) more that offsets any penalty. You decide using the spreadsheet http://www.retailinvestor.org/OutorIn.xls

    3) The question "Should anyone own preferred shares" should not be answered with any assumption about the type bought. There are different types. My returns from perpetual preferred this YTD and for the past 3 years has been better than the TSX.

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