Trust-tax issues spur return of preferred shares

(March 2007) As income trusts become less attractive to investors, a more traditional investment option is returning to the limelight, as investors take a second look at preferred shares.

According to the Investment Industry Association of Canada’s recently released report on new issuance and trading in Q4, the value of preferred share issuance has jumped 154.2% over Q3 2006. The number of preferred share issues has increased 175% from Q3, with 31 issues year-to-date.

“A number of things came together in the fourth quarter,” says Ian Russell, president of the IIAC. “The first thing that changed was you had the Halloween episode with income trusts. We saw a real fall in their value because of the tax changes.”

Russell says the income trust’s grandfathering clause might keep some cash in the market, but with so much volatility, preferred shares are the new go-to investment option. “There will be a lot of structural changes to income trusts over the next four years,” he says. “Even if you want to ride it out and benefit from the grandfathering provisions, it’s not an attractive place to be.”

Another reason preferred shares’ popularity has increased is the government’s decision last April to cut taxes on dividends. Preferred shares, which assume characteristics of both stocks and bonds, pay regular dividends to shareholders, so paying less tax on an investment will naturally appeal to investors, says Russell.

The biggest draw to preferred shares, though, is demand for high yield products. YPG Holdings, a subsidiary of Yellow Pages Income Fund, announced in February that it was offering preferred shares with a 4.25% yield, and Scotiabank’s latest offering yields 4.50%.

“Preferreds are able to offer a yield that will be attractive to the market, given alternatives,” says Russell.

Investors are also attracted to the preferred share market because it is populated by strong, more secure companies, such as banks and utilities.

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“All in all, a confluence of events has created an appeal for them,” he says. “When there’s an appeal coming from the marketplace, issuers are always looking to design an instrument that lowers their cost of capital.”

Kevin Hall, a portfolio manager at Guardian Capital, has seen the demand for preferreds increase but says there aren’t enough options in the marketplace. “There is a lot of demand for tax-efficient, higher yielding products, but there’s a contracting supply for the most part.”

From Q4 2005 to Q4 2006, the number of preferred shares issued has actually dropped 16.2%. This has forced Hall to close his fund, the GGOF Monthly Dividend Fund, to new investors. Preferred shares account for more than 50% of the portfolio.

Capping the fund was a tough decision. “It’s always difficult when you’re faced with that choice,” he says. “But we were having difficulty finding product, so the fund was capped to protect and preserve the existing unitholders.”

Since January, though, companies such as YPG, Sun Life Financial and CIBC have offered preferred shares, another indication that the market may be on the rebound.

YPG decided to issue preferred shares, says the company’s senior manager of investor relations, Anne Sophie Roy, because it is an attractive form of financing. “The coupon that we paid, 4.25%, was just lower than our average cost of debt.”

Roy adds that YPG felt the market lacked a high quality yield instrument for retail investors. “This instrument really helps us tap into a new pocket of demand,” she says. “For us, it’s a new market.”

With the lower tax on dividends and the declining interest in income trusts, Russell says the market can only strengthen.

But preferred shares are not entirely without risk. If the issuing company flounders, dividend payments may dry up and the potential upside isn’t the same as if you purchased a regular stock. “If you are looking for growth in the share price, you’re better off in stock than preferred,” says Russell. He adds, however, that people are willing to sacrifice growth for yield.

With strong companies putting out preferred shares, Russell doesn’t anticipate any problems with Canadian-issued shares. “You’ve got a good yield, with a solid company. Some portfolios want that income. I don’t think there is a con to preferred shares.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@rci.rogers.com

(03/07/07)

Bryan Borzykowski