For 30 years, fixed income was the part of your portfolio that under-promised and over-delivered. Today bond holdings have become considerably less attractive, combining paltry yields with a high possibility of capital losses year to year as interest rates tick upward from historic lows. For older investors reliant on the income they provide, there are few options to boost yields (high-yield corporate bonds, dividend stocks) and they all involve greater risk.
One alternative worth considering right now is the preferred share ETF. Preferred shares occupy the middle ground between equities and fixed income. Generally issued by blue-chip companies, they are shares that act like bonds, promising a set payout over a set term and usually varying little in price. While preferred shares are difficult instruments to hold individually they are easily accessed through exchange-traded funds.
The appeal of preferred share ETFs
The appeal of preferred funds is they offer higher yields than bond ETFs, explains Alfred Lee, vice-president of BMO Global Asset Management and lead manager of the bank’s Laddered Preferred Share Index ETF (TSX: ZPR). Plus, their distributions are considered dividends, as opposed to interest, by the taxman. “So they’re not only higher, they’re more tax efficient,” Lee says.
And in Canada, where the bulk of the preferred share universe is of the rate-reset variety—instead of offering a fixed payout perpetually, their coupon is reset in relation to the five-year Government of Canada bond rate every five years—they may offer more protection than bond funds from rising interest rates.
“Anyone should consider using a Canadian preferred share index ETF as an alternative to a corporate bond ETF allocation because an investor will pick up at least 1% in current yield without taking on any more credit risk,” says Terry Shaunessy, president and portfolio manager at Shaunessy Investment Counsel in Calgary.
The risk trade-off
Allocating some of your fixed income to preferred ETFs does come with a trade-off in risk, however. In the event of the issuer’s bankruptcy, bondholders take priority over preferred shareholders in recouping their investment (who in turn rank ahead of common shareholders). This risk is lessened somewhat in a widely invested fund. But if the main purpose of your fixed income is to provide ballast to your portfolio, you’d best stick to bonds, advises Chris Turnbull, founder of The Index House in Edmonton and self-described “conservative, boring” investor.
“There are other factors that affect the value of preferred shares than just interest rates,” he says. The iShares S&P/TSX Canadian Preferred Share Index ETF (TSX: CPD), one of the longest-trading preferred share ETFs on the market, experienced slumps approaching 30% in 2008 during the financial crisis and again in 2014-15. “We’ve seen this preferred drop twice in 10 years,” Turnbull notes. While he could see allocating up to 10% of your total holdings to preferreds, any more will likely cause you to stray from your target asset allocation, since preferreds are technically equities.
But if you have concerns about rising interest rates, and maximizing income is a priority, preferred ETFs should make a good complement to your bond holdings.
Preferred share ETF best bets
iShares S&P/TSX Canadian Preferred Share Index ETF (CPD): Cap-weighted fund reflecting the broad market for Canadian preferreds. (MER: 0.51%)
BMO Laddered Preferred Share Index ETF (ZPR): Laddered fund of strictly rate-reset preferreds, 20% of which will reset their payout in any one year, which reduces the interest rate risk. (MER: 0.50%)
Horizons Active Preferred Share ETF (HPR): A fund actively managed by Fiera Capital. “Fiera typically beats the preferred share index by more than the price difference,” says Terry Shaunessy of Shaunessy Investment Counsel. (MER: 0.64%)
BMO U.S. Preferred Share Index ETF (ZUP): Cap-weighted fund invested in U.S. preferred shares (which typically have fixed distributions), offering geographical as well as currency diversification. (MER: 1.16%)
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First published on March 31, 2017