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Preferred Shares Explained: Stock or Bond — What Are You Buying? | Canadian Investing · How Canadian Markets Work

0:00
Imagine buying an investment that is specifically
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designed to trap your money and just completely
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stop paying you during a financial crisis. Right,
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and doing it entirely on purpose. Yeah. doing
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it on purpose just to save a few dollars on your
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taxes. Welcome to the bizarre and honestly often
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completely misunderstood reality of the Canadian
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preferred share market. Today we are taking a
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massive stack of source material, so financial
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notes, articles, and research covering the mechanics
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of Canadian capital markets. We're going on a
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deep dive to decode the preferred share. It's
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a very needed deep dive, honestly. It really
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is because rather than relying on that tired
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oversimplified definition that calls it a hybrid
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between a stock and a bond, which I feel like
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just confuses people more. Oh, absolutely. It
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leaves people with a zero understanding of the
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actual risk. Right. So we're going to look at
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this instrument backwards. We want to understand
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it through the specific problem the issuing company
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is trying to solve. So let's unpack this. To
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really get what this asset is, we have to look
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past the marketing and understand where the investor
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actually stands in line on a company's absolute
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worst day. That is the essential starting point,
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because when we talk about a company's capital
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structure, we are essentially looking at a legally
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binding priority queue. Right. And preferred
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shares sit squarely in the middle of that structure.
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So they have a higher priority than common shares,
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but they are strictly subordinate to all forms
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of debt. Subordinate meaning they are behind
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them in line. Exactly. Behind the bondholders,
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behind the banks, and that structural placement
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dictates everything about the instrument. from
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who receives cash flow during normal economic
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times to who gets whatever scraps are left over
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in the event of a liquidation. Well, let's ground
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that in a tangible mechanism because people often
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gloss over what capital structure actually means
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in practice. So think of a company's capital
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structure like a commercial real estate lease.
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The bondholders, the debt holders, they're the
1:58
primary landlord of the building. I like this
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analogy. Yeah, so if they don't get paid their
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rent on time, They have the legal authority to
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lock the doors, seize the building, and literally
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liquidate the assets to get their money back.
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Right. That is a much more accurate framework.
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Their claim is a legally binding contract with
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severe immediate consequences if breached. And
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then you have the preferred shareholders. In
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this commercial lease scenario, They are like
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the subtenants who, I don't know, secured the
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premium corner offices. Nice offices. Right.
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They get their space or their payout before the
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general workforce in the cubicles. Which would
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be your common shareholders. Exactly. But if
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the primary landlord locks the doors because
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the company goes broke, it doesn't matter how
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nice that corner office is. Nobody inside is
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getting a dime. Nobody. Which perfectly illustrates
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the vulnerability of that middle position. You
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have priority over the common equity, absolutely.
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But if the enterprise value drops below the total
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amount of debt owed to those primary landlords,
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your preferred equity is wiped out just as cleanly
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as the common stock. Oof. Gone. Gone. Yet despite
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the structural vulnerability, preferred shares
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are engineered with features that make them feel
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incredibly similar to bonds to the person holding
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them. Well, that bond -like illusion comes directly
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from the payment structure. Based on the financial
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notes we're reviewing, preferreds typically pay
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a fixed dividend based on a set par value. Right.
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And in the Canadian market, this is overwhelmingly
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standardized at a $25 par value. Yeah, let's
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walk through the mathematics of that so the mechanics
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are totally clear. If an investor purchases a
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5 % preferred share, it pays them a 5 % yield
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strictly on that $25 par value. So mathematically,
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that works out to exactly $1 .25 per year, which
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is predictably distributed in quarterly installments.
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So it feels exactly like a bond coupon. Exactly
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like it. But because that payout is a rigid,
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fixed dollar amount, the market price of the
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preferred share has to move inversely to interest
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rates, just like a bond. Correct. So if the central
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bank raises interest rates and suddenly newly
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issued bonds are paying six or seven percent,
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nobody's going to pay the full twenty five dollars
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for an older preferred share that only yields
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five percent. No, why would they? Right. The
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open market price of that share must drop, maybe
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down to $20 or less, until that $1 .25 payout
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represents a competitive yield in the new economic
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environment. Yeah, the gravity of interest rates
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applies to preferred shares just as ruthlessly
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as it applies to traditional bonds. Yeah. And
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furthermore, to complete this bond -like package,
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preferred shares are generally non -voting under
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normal operating circumstances. Oh, interesting.
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Yeah. The investor is providing capital, but
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they have absolutely no voice in corporate governance,
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board elections, or strategic direction. OK,
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so if I'm synthesizing this correctly, the entire
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structure is kind of a paradox. It looks like
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a bond, it is priced by the market like a bond,
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and it pays out like a bond. Calling it equity
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feels almost like a technicality. Why isn't this
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just classified as debt? Because of one structural
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reality that completely separates it from debt,
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the dividend on a preferred share is not a legal
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obligation. It is a stated priority over the
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common shares, but it is fundamentally not a
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promise. Wait, wait. If there is no legal obligation,
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the company can just unilaterally decide to turn
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off the cash flow. Yes. But that fundamentally
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alters the risk profile. Because, I mean, if
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a company misses a single coupon payment on a
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bond, they're in technical default. Instant default.
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Right. The creditors initiate insolvency proceedings.
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But if they miss a preferred dividend, Nothing
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happens. Nothing happens from a legal standpoint.
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There are no bankruptcy triggers pulled. No creditors
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step in to seize the commercial building, to
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use your earlier analogy. The company simply
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retains the cash. And this lack of a legal guarantee
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is the precise reason why a company's preferred
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shares will always offer a higher yield than
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that exact same company's bonds. Because it's
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riskier. Exactly. The investor is being explicitly
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compensated with a higher yield for holding a
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significantly weaker claim on the company's cash.
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OK, that clarifies the yield premium. The investor
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is trading absolute legal certainty for a higher
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payout. But there has to be some mechanical backstop.
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Yeah. Like if a company hits a mile speed bump
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and decides to conserve cash by just turning
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off the preferred dividends, they can't just
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operate business as usual and funnel money to
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the common shareholders, can they? No, they cannot.
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And that brings us to the structural protections
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built into these instruments, primarily through
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what are known as cumulative preferred shares.
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Cumulative. Right. If an issuer suspends the
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dividend on a cumulative preferred share, that
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obligation doesn't disappear. It actually accumulates
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on the balance sheet as arrears. OK. So using
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our earlier math of a $1 .25 annual dividend,
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if they suspend it in year one, the arrears are
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$1 .25. If the suspension lasts through year
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two, the arrears compound at $2 .50. By year
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three, the company owes $3 .75 per share. You've
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got it. And the critical protection here is a
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structural blockade on the company's capital
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distribution. What does that mean? It means the
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issuer is legally prohibited from paying a single
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cent in dividends to their common shareholders.
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And they're typically prohibited from buying
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back common stock too. Ooh. Yeah, until every
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single penny of those accumulated preferred arrears
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is cleared. So they are blocked completely? Completely.
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That is a massive deterrent because corporate
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boards are terrified of cutting dividends. It
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instantly signals severe financial distress to
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the broader market which usually causes the stock
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price to just plummet. Right. So suspending the
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preferred dividend effectively traps the common
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equity holders. It's a lever management will
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only pull if they're in genuine cash burning
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distress. Exactly. It functions exactly as a
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deterrent should. But we have to contrast that
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with the alternative structure. Non -cumulative
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preferred shares. In a non -cumulative structure,
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if the board of directors elects to skip a quarterly
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dividend, that money is simply gone forever.
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It's gone. There are no arrears. There is no
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requirement to make the investor whole in the
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future. That seems like a structurally terrible
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proposition for the investor. Yeah. I mean, you
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take on all the downside risk of the equity position
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without any of the contractual protections of
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debt, and the company can just vaporize your
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income stream at will. Pretty much. Why would
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the market even support the existence of non
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-cumulative shares? Why would anyone buy them?
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Well, what's fascinating here is that the prevalence
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of non -cumulative preferreds is heavily concentrated
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in the banking and insurance sectors. And the
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driving force behind this is entirely regulatory.
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Regulatory? Yes. Financial regulators, the entities
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responsible for the stability of the entire banking
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system, actively demand instruments that can
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absorb losses without triggering a systemic collapse.
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Oh, wow. Okay, I see the mechanics of that now.
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If a major bank is facing a severe credit crisis,
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say a massive wave of mortgage defaults, their
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capital reserves are bleeding out. Right. And
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if their preferred shares were cumulative, Or
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worse, if they were classified as dead, the bank
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would be legally forced to keep hemorrhaging
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cash to pay those investors, accelerating their
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path to bankruptcy. Exactly. From the regulator's
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perspective, an instrument that allows a struggling
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bank to legally stop paying dividends and retain
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that cash to stabilize its balance sheet is a
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feature, not a bug. A feature for the system.
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Yes. It acts as a necessary shock absorber for
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the financial system. But from the perspective
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of the retail investor relying on that fixed
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income, income, that deliberate systemic feature
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translates into an incredibly weak individual
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claim. Man, this logic brings us full circle
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to the core mission of our analysis today, which
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is looking at this backwards. If we analyze the
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issuer's motives, it becomes so clear why corporate
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Canada issues this complex instrument instead
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of simply taking out a loan or selling more common
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stock. Right. And the issuer's motives really
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break down into three distinct pillars. The first
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pillar is accounting and regulatory treatment.
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Because of the discretionary nature of the dividends,
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preferred shares are typically classified as
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equity or regulatory capital on the balance sheet
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rather than bet. Which artificially improves
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their debt to equity ratios. Bingo. They secure
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millions in funding, but because it doesn't show
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up as a rigid scheduled liability, they still
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look incredibly healthy to future lenders and
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credit rating agencies. Precisely. And the second
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pillar revolves around corporate control. Common
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stock carries voting rights. So if a company
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issues a massive block of new common shares to
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raise capital, the existing founders, management,
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and major shareholders, they dilute their voting
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power. But preferred shares generally do not
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carry voting rights. This allows management to
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raise substantial capital without surrendering
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an ounce of operational control. OK, so what
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does this all mean? They get... favorable accounting
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treatment, they retain total voting control,
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which leaves the third pillar, which I'm assuming
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is cash flow flexibility. They are engineering
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an escape hatch. If the macroeconomic environment
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deteriorates, they can immediately halt the cash
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outflow without triggering a catastrophic default.
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The investor is providing the capital of a lender
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but accepting the flexibility of an equity holder.
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That is the perfect summary. Ultimately, the
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issuer's flexibility is precisely the investor's
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risk. the instrument is fundamentally asymmetrical
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by design. That realization just completely changes
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how an investor should view their portfolio.
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You aren't buying a perfect harmonious hybrid.
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You are literally buying the issuer's financial
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escape hatch. So let's take these raw mechanics
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and apply them directly to the everyday learner
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who is building a portfolio in Canada because
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the source material highlights several unique,
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often dangerous realities specific to the Canadian
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market. Oh, yeah. And the most prominent of those
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realities is what we should term the tax illusion.
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The tax illusion. This is a trap that catches
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so many yield chasing investors because in Canada,
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preferred share dividends paid by Canadian corporations
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are eligible for the dividend tax credit, whereas
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standard bond interest is taxed fully as regular
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income. Right. And the mathematical result of
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that tax treatment in a non -registered taxable
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account is highly persuasive. Very persuasive.
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An investor looking at a preferred share yielding
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five percent will walk away with notably more
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after -tax capital than if they held a corporate
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bond yielding the exact same five percent. The
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gross up and credit mechanism of the tax code
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significantly favors the dividend. But the illusion
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lies in the comparison itself. Yes. Investors
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look at a bond yielding five percent, then they
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look at a preferred share yielding five point
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They factor in the dividend tax credit, see a
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massive bump in their after -tax income, and
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allocate their capital to the preferred share,
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believing they just made a brilliant efficiency
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play. They think they outsmarted the system.
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Exactly. But they are completely blinded to the
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fact that they just traded a senior legally binding
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debt obligation for a subordinate discretionary
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equity claim. That is the trap. They are comparing
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the yields as if the underlying risks are identical,
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which, as we've established today, is entirely
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false. They are accepting a priority rather than
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a promise, absorbing significant equity like
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risk purely to optimize a tax outcome. Just to
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save on taxes. Yeah. Which cascades perfectly
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into the next major Canadian portfolio reality,
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which is sector concentration. A huge issue.
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Right. The notes we are reviewing stress of the
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Canadian preferred share market is surprisingly
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small and incredibly monolithic. It is overwhelmingly
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dominated by the financial sector, specifically
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the big domestic banks and life insurance companies.
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Yeah. When you look at the issuance data, non
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-financial corporate preferred shares, so say
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from utilities or telecom companies, they make
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up a very small minority of the available market.
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This triggered a massive aha moment for me while
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reviewing the research. Oh, yeah. Yeah, think
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about the standard prudent Canadian retail investor.
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They are told to diversify. So their core holding
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is a broad TSX composite index fund. A very common
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approach. Right. But because the Canadian economy
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is structured the way it is, that index is already
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heavily weighted toward financial institutions.
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Right. Then, because Canadian banks have a history
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of paying strong common dividends, the investor
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probably buys individual common stock in a few
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of the big six banks. Also very common. Right.
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And finally, they want a fixed income substitute
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for their taxable account. So they buy a Canadian
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preferred share ETF. Oh, boy. Which is 70 to
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80 percent financials. It is the ultimate illusion
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of diversification. They believe they have constructed
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a balanced portfolio of broad market indices,
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individual equities and fixed income alternatives.
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In reality, they have simply purchased the exact
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same Canadian banking sector risk three times
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over, wrapped in different packaging, three times
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over. So if the financial sector experiences
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a severe systemic shock, like a housing market
15:09
correction, for example, their entire portfolio
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implodes simultaneously. Everything goes down.
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The index fund drops, the common bank stocks
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plummet, and those supposedly stable preferred
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shares will drop rapidly. Or worse, the banking
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regulator will step in and mandate a suspension
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of those non -cumulative dividends to preserve
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capital. The investor has inadvertently built
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a structurally monolithic portfolio while thinking
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they were diversified. It is a textbook manifestation
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of overlapping risk. And compounding that sector
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concentration is another deeply embedded structural
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risk, which is perpetual duration and liquidity
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traps. Perpetual duration. Let's define duration
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here. Because earlier we established that traditional
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straight preferred shares do not have a maturity
15:54
date, they're perpetual instruments. Right. And
15:56
to understand why that matters, we need to contrast
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it with bond mechanics. If you hold a standard
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five -year corporate bond and interest rates
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rise sharply, the market price of your bond will
16:05
drop. Sure. However, that pain is temporary.
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As the bond approaches its maturity date, the
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price is mathematically pulled back to its par
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value because the company is contractually obligated
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to pay you back the principal on that specific
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date. OK, but a perpetual preferred share has
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no maturity date. There is no contractual date
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where the company must hand you back your $25.
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Therefore, there is absolutely no mechanism to
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pull the price back to par over time. Precisely.
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Because there is no maturity horizon, the duration,
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which is essentially a measure of sensitivity
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to interest rate changes, is extremely long.
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If interest rates rise significantly, the price
16:44
of a perpetual preferred share falls and you
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are permanently trapped in that depressed price
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unless rates eventually fall back down. Wow.
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You either accept the subpar yield forever or
16:55
you sell the asset at a permanent capital loss.
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And selling at a loss introduces the final trap,
17:00
liquidity, because the Canadian preserved market
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is relatively small. When interest rates spike
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and retail investors suddenly realize their capital
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is trapped in a depreciating asset, they all
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rush for the exits at the exact same time. Yep.
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But because institutional buyers often step away
17:15
during these volatile periods, the trading spreads
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widen dramatically. It's awful. You find yourself
17:21
holding a highly rate sensitive asset in a highly
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concentrated market. And when you finally decide
17:26
you want out, there is no one on the other side
17:28
of the trade willing to give you a fair price.
17:31
The structural design of the instrument works
17:33
entirely against the investor during a panic.
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Man, this has been an incredibly revealing teardown
17:40
of the source material. We've taken an asset
17:42
that is usually explained away in a single sentence
17:45
and exposed the deep mechanical realities underneath
17:48
it. So just to summarize the critical takeaways
17:51
from today's analysis, preferred shares are not
17:54
a neat hybrid. They are a specific structural
17:57
compromise sitting strictly between common equity
17:59
and debt. They offer a fixed bond -like payment,
18:02
but crucially, they lack the legal contractual
18:05
promise of a bond. Whether they are cumulative
18:07
or non -cumulative, every feature of preferred
18:10
shares engineered to balance the issuing corporation's
18:13
critical need for balance sheet flexibility with
18:15
the investor's desire for a tax -advantaged income
18:17
stream. Exactly. And in the Canadian market,
18:20
pursuing that tax advantage often leads investors
18:22
into severe sector concentration and perpetual
18:24
duration risk. The mechanics we've explored dictate
18:27
the reality of the asset. But looking beyond
18:30
the current mechanics, there is a broader structural
18:32
shift occurring that investors really need to
18:35
consider. As global banking regulations, specifically
18:38
frameworks like Basel III, become increasingly
18:41
draconian about what genuinely qualifies as tier
18:44
one capital for financial institutions, regulators
18:47
are demanding even more aggressive loss absorbing
18:50
features. Yeah, we may well be looking at the
18:53
twilight of the traditional preferred share entirely
18:56
as banks are forced to transition to even more
18:59
complex contingent capital instruments that are
19:02
far less friendly to the retail investor. That
19:04
is a fascinating forward -looking reality to
19:07
leave our audience with. Because if the regulations
19:09
driving the creation of these assets are evolving,
19:12
the assets themselves might soon become obsolete,
19:15
replaced by instruments with even wider escape
19:17
hatches for the issuers. Which means, if you
19:20
have been treating the preferred shares in your
19:22
portfolio as a safe, simple fixed -income substitute,
19:26
it is time to thoroughly audit what you actually
19:28
own. Look at the capital structure, analyze your
19:32
true sector exposure, and ask yourself exactly
19:34
whose financial problem your capital is solving.
19:37
Are you just acting as the uncompensated shock
19:39
absorber for corporate Canada's worst days? Exactly.
19:43
Keep questioning the consensus definitions. Thanks
19:45
for joining us on this deep dive into the source
19:47
material.