In previous years, retirees were able to invest their capital in ultra-safe investments like GICs and Government of Canada bonds, confident in knowing they’d throw off enough income to fund their retirement.
In 2015 it’s a whole different story. GICs and government bonds barely even keep up with inflation, so investors have been forced to take a little more risk in order to get income. Dividend-growth stocks have become popular, as have high-yielding sectors like REITs.
Lately, thanks to fears of higher interest rates across the border, a whole new asset class has sold off to the point where I think income-oriented investors should be interested. I sure am. That asset class is preferred shares.
Let’s take a closer look at these shares, with one in particular that can really supercharge an investor’s income.
The basics of preferred shares
In the hierarchy of a company, preferred shares end up between bonds and common shares. If the company remains healthy, the preferred shares will trade just like bonds, rising and falling based on interest rate expectations and the quality of the company’s balance sheet. If the company struggles, they’ll fall, although usually not as much as the common shares.
In Canada, there are a couple different common types of preferred shares. The first are called perpetual preferreds, which have no set expiration date, but they can usually be redeemed at $25 per share at any point after five years. They pay a steady dividend that never changes.
The other type is called a rate reset preferred, which means after the original five-year term is up, the interest rate paid to investors resets to a value originally disclosed in the prospectus. Usually the new rate is whatever the Government of Canada five-year bond yields, plus a risk premium of anywhere from 1-4%, depending on the credit worthiness of the issuer.
The opportunity in Great-West Lifeco
Although the Bank of Canada doesn’t look like it’s about to raise rates, many Canadian preferred shares have sold off lately based on expectations that a rate hike from the U.S. Federal Reserve will also increase interest rates in Canada.
This has created an opportunity for income investors, which has driven up yields in preferred shares issued by some of Canada’s finer companies.
One example is Great-West Lifeco Inc. (TSX:GWO), one of Canada’s largest life insurers. It has several different series of preferred shares outstanding. We’ll focus primarily on the Series F preferreds (ticker symbol GWO.PR.F), which are a perpetual preferred share that have traded since 2005.
Over the last few months, these shares are down from a high of $26 to today’s level of $25.15, which has pushed the yield up to 5.9%. That’s a yield nearly 50% higher than the common shares—which pay a 4% dividend—with a whole lot more price stability.
Sure, investors in the common shares get a greater potential for growth, both in the share price and the dividend. But Great-West Lifeco’s dividend has only been hiked once in the past five years, and it seems like the whole financial sector is trading at ultra-low P/E ratios. An increase in interest rates will likely boost the company’s bottom line, but it needs serious rate hikes for profit to really go up. Rates going up a quarter or a half of a percent isn’t really going to affect profits that much.
That’s the trade-off an investor has to make. If you want income, sometimes you have to give up the potential for capital gains. And remember, preferred share dividends will be paid before common share dividends because preferred shares are higher on the capital structure. That makes preferreds the safer income choice.
Great-West Lifeco is a solid operator with a good balance sheet and strong earnings. It easily earns enough to cover all of its obligations, including preferred share dividends. For an income investor, I’d suggest taking a closer look at any of the company’s preferred share issues.
