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It’s been a tough year to be a bond investor.
Well, technically, it’s been a tough year for every investor, but the interest rate environment of 2022 has been especially bad for bond investors.
Traditional portfolio management operates under the assumption of stocks and bonds being anti-correlated with each other, meaning that when one moves up the other goes down and vice versa. It also operates under the model of stocks being volatile while bonds are safe.
2022 has blown up both rules.
Year to date, the S&P 500 has gone down by about 15% for a variety of reasons like rising interest rates, the war in the Ukraine, and record high inflation. We don’t like it, but at least it makes sense.
Bonds, however, have completely failed this year in their role as a counter-balance to the stock market’s volatility. An aggregate bond index like VSB (Canadian) or BND (American) has fallen about 10%. What the Hell!
The reason for this is, of course, interest rates. When interest rates rise, the price of existing bonds fall, which is expected. What wasn’t expected, however, was all this stuff happening all at once. On multiple occasions, I’ve tried to write an article comparing 2022 to previous recessions in an attempt to reassure everyone that things will work out just fine, but I’ve had to abandon that article multiple times because I just can’t find a similar enough situation in the past. A pandemic, plus a war, plus high inflation, plus rising interest rates, plus a housing correction, all in one year? It’s never happened before. We are in uncharted territory here, people!
Which is both a bit scary and a bit exciting. Scary because without a clear historical precedent, it’s impossible to predict what will happen next. But a bit exciting because there might be opportunities that appear that don’t happen often.
I think we might be in that situation with preferred shares.
Now, before I dive into things, it’s worth repeating that this is not financial advice. I am just some dude on the Internet sharing his thoughts. Do with it what you will.
Preferred Shares
Preferred shares are more complicated than traditional stocks and bonds, and therefore not for everybody. But for people who have the time and interest to dive into these, they can be quite an interesting asset class.
For starters, preferred shares are neither equities nor bonds. They’re kind of a hybrid, and have qualities of both. Like equities, they’re issued by companies and trade on the stock market. Like equities, they also pay a dividend rather than interest, and can be used as a way to receive tax-advantaged income in retirement.
However, owning them doesn’t give you an ownership stake in the company like equities do. You can’t use them to vote at shareholder meetings (which few people do anyway).
Something that’s also interesting about preferred shares is that they can be issued as a fixed rate or as rate resets. Fixed rate preferred shares are, as the name implies, issued with a fixed interest rate that never changes, similar to a traditional bond.
Rate reset preferred shares, on the other hand, are issued with an interest rate that’s defined by a spread to the central bank’s benchmark rate. For example, a rate reset preferred share might be issued at the current 5-year yield + 2%. So when interest rates rise, rate resets will “reset” their interest rate higher to match, hence the name.
This makes rate reset preferred shares one of the few asset classes that should rise with interest rates. As interest rates rise, rate resets should hike their dividends, which makes them more valuable, which should make their prices go up.
The reality
Note that I said “should.” Because the reality has been quite different.
Since the beginning of 2022, as it became increasingly obvious that interest rates were going to go up around the world, I’ve been watching the preferred share market closely to see if they would behave the way I was expecting.
They did not.
Instead of going up with interest rates, preferred shares has gone straight down.
So what gives?
Here’s the thing. I’ve been searching for an answer for the better part of a year now, and I still haven’t found one. Preferred shares are typically issued by stable blue-chip companies like banks, insurers, utilities, etc, and if those companies were in trouble and defaulting on their payments, that might explain the sudden drop in price. But no banks or utilities are falling over right now, so that’s not it.
The only explanation I was left with is that the price drop in preferred shares is irrational and way oversold.
Here in Canada, preferred shares are mostly owned by unsophisticated retail investors, so it’s entirely possible many of them panicked as the stock market dropped and simply sold everything and moved to cash. It’s also entirely possible that retail investors aren’t understanding the difference between fixed-rate and floating rate preferred shares, because both asset classes have been going down this year when they should be going in opposite directions.
As a result, I think floating-rate preferred shares are underpriced right now.
Now, don’t get me wrong. I’m not trying to outguess the market here. I have no idea when or even if this asset class will “snap out of it” and start rallying like they’re supposed to. So on it’s own, this doesn’t make preferred shares an attractive opportunity.
What does, however, is their yield.
Even while prices have been falling, rate resets have been quietly resetting their rates as advertised. This has caused the yields on an ETF tracking rate-reset preferred share like ZPR to slowly rise over the year.
During the pandemic, a Canadian floating-rate preferred share ETF like ZPR was yielding around 4%. Not bad, but not too crazy. Over time, however, that yield has been going up as interest rates have risen.
As of the time of this writing, the yield on ZPR is hovering around 6%! On the US side, something similar is happening on a floating-rate preferred share ETF PFFV, also currently yielding around 6%.
I haven’t seen a yield that high for preferred shares in…well…ever! A 6% yield is usually reserved for super risky investments like junk bonds, but ZPR shares are issued by stable blue-chip companies in no danger of going into default. And given that a traditional bond index is yielding only 3.5% while also not providing the stabilizing anti-correlated effect they’re supposed to, what exactly am I giving up that extra potential yield for?
Why This Makes Sense For Retirees
Now, to be clear, owning preferred shares doesn’t make sense for everyone. If you’re still in the accumulation phase of your FIRE journey, stick with plain vanilla stock and bond index ETFs. The added complexity isn’t worth it if you don’t need the income, and for that reason my recommendations in the Investment Workshop haven’t changed since the Workshop is directed at newer investors who are still working.
However, if you’re retired (or close to it) and looking to build up (or enhance) your Yield Shield, then this move might make sense. This is my current portfolio’s yield.
Note that the Income column is calculated by taking the asset class’s yield, multiplying by its allocation, then multiplying by our portfolio’s current total value of $1.8M. Adding up this column gives us our total portfolio income in the bottom right corner.
| Asset Class | Yield | Allocation | Income |
| Short Bonds | 2.60% | 10.00% | $4,680.00 |
| Preferred Shares | 5.91% | 0.00% | $0.00 |
| Canadian Index | 3.13% | 30.00% | $16,902.00 |
| US Index | 1.55% | 30.00% | $8,370.00 |
| EAFE Index | 4.89% | 30.00% | $26,406.00 |
| Total | $56,358.00 |
This is Portfolio A, which is set up as a 90% equity/10% fixed income split. This may seem aggressive for an early retiree, but as our analysis showed us at the end of 2021, because our portfolio has grown so much since we left, we can tolerate a lot more volatility now than when we first retired while still maintaining a 100% success rate on FIRECalc.
Now let’s see what happens when we add preferred shares to the mix by selling our short-duration bond fund and adding in a preferred share index yielding 6%.
| Asset Class | Yield | Allocation | Income |
| Short Bonds | 2.60% | 0.00% | $0.00 |
| Preferred Shares | 5.91% | 10.00% | $10,638.00 |
| Canadian Index | 3.13% | 30.00% | $16,902.00 |
| US Index | 1.55% | 30.00% | $8,370.00 |
| EAFE Index | 4.89% | 30.00% | $26,406.00 |
| Total | $62,316.00 |
My income jumps to $62,316, so it goes up 11% just from this change. And honestly, bonds aren’t doing a great job of shielding me from volatility right now anyway.
Another option is to adjust this mix to a more even 75% equity/25% preferred shares allocation, essentially making all 4 asset classes equally weighted. What does this do to my yield?
| Asset Class | Yield | Allocation | Income |
| Short Bonds | 2.60% | 0.00% | $0.00 |
| Preferred Shares | 5.91% | 25.00% | $26,595.00 |
| Canadian Index | 3.13% | 25.00% | $14,085.00 |
| US Index | 1.55% | 25.00% | $6,975.00 |
| EAFE Index | 4.89% | 25.00% | $22,005.00 |
| Total | $69,660.00 |
My portfolio yield now rises to almost $70k!
I gotta admit, that’s pretty tempting. With this mix, I’m still aggressively invested in traditional index funds. I’ve gotten rid of bonds, so my portfolio is going to be more volatile (but again, I’m OK with this), and my yield of $70k is completely based on dividends, which are tax-free due to the dividend tax credit. So I get a raise in income, and my tax burden goes down at the same time!
Conclusion
While I was working and saving for retirement, I invested completely passively and just rebalanced to my targets every month while ignoring the news. It was simple, and it worked.
In retirement, however, I’ve found my investing strategy subtly change. Rather than focusing on controlling our portfolio’s volatility, we’re finding ourselves more focused on our portfolio’s yield, since that’s what we actually need to live on.
As a result, we’re not really spending any time following the stock market, and instead watching out for deals in the fixed income and Yield Shield assets. And right now, Preferred Shares are flashing “DEAL! DEAL! DEAL!” to us.
What do you think? Do you think it’s a good time to invest in Preferred Shares, or do you think there’s still more room to fall in that asset class?
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Thanks for the concise explanation. I’d been wondering exactly how to get into preferred shares and should’ve guessed that ETFs exist (I just didn’t see one on the Vanguard list; apparently Vanguard Adjustable Rate Preferred Stock Fund is no longer a thing).
(Un)fortunately we’re accumulating for another eight years or so and can’t quite take advantage of current conditions. I’m sure there will be a whole new set of unprecedented circumstances in 2030 when our house is paid off and we’re ready to pull the FIRE trigger. Hope y’all are still around to break it down!
Wow! Preferred shares sound great! Will I actually invest in them?? I don’t know if I should pull the trigger…
Hmmmm, when I googled ‘rate re-set preferred shares’ I found this:
Rate-Reset Preferreds: A rate-reset preferred share offers a fixed dividend payment where the rate of that payment is reset upon a specific date, typically every five years. Generally, the rate will be a pre-determined spread above a government bond with a similar term.
If I’m understanding this correctly, only the preferred shares that are up for renewal now would be reset to match in jump in interest rates. Everything else would stay at whatever it was set at until time for it to renew? Am I interpreting that correctly?
Initially, I was going to slot the entire 30% on Preferred in lieu of BONDs but have decided to split this evenly at 15% each to achieve a 70/30 allocation. I was also “shadowing” a particular strategy. To date, I am still ok with our initial decision to mirror BUT I did have an inclination at the start. Being a ‘”newbie” at that time, I just did not know or was not comfortable enough to execute.
Should’ve, would’ve, could’ve…
ImmigrantOnFIRE
Initially, I was going to slot the entire 30% on Preferred in lieu of BONDs but have decided otherwise to split it evenly at 15% each to attain a 70/30 allocation. I was also trying to “shadow” a particular strategy. That said, I am still comfortable with our decision to mirror. Being a “newbie” at the time, I just did not know or was not comfortable enough to execute BUT…
Should’ve, would’ve, could’ve
ImmigrantOnFIRE
All this sounds good in theory. But in practice, how does one re-balance from a portfolio of 90% equity/10% bonds (or even 60%/40%) to a portfolio with significant Preferred Shares exposure without triggering a tax event?
Hey Wanderer! Thanks for writing such a fascinating article, and I totally agree. I actually bought my first ever preferred shares earlier this year… and I have plans to buy more. It looks like you buy a preferred share index, not individual stocks. I’d prefer (no pun intended, LOL) to do that, but all the preferred shares index funds I’ve found have such high expense ratios. Ugh. Which is why I actually bought an individual stock to get my preferred shares (that’s the first time I’ve bought an individual stock as well).
I am a bit surprised by this: “Here in Canada, preferred shares are mostly owned by unsophisticated retail investors, so it’s entirely possible many of them panicked as the stock market dropped and simply sold everything and moved to cash.” Maybe I’m wrong, but my impression was that in the US, unsophisticated retail investors aren’t buying preferred shares (they barely even know preferred shares exist, at least from what I’ve seen). Things must be different up there. Or else I’m mistaken about who buys preferred shares in the US, haha.
Does Vanguard sell Preferred Shares? I can’t find the expense ratio. Any insights?
Forget Vanguard. It’s not all that is out there…They get a good rep from JL Collins but that’s all
How about moving into 1 year GICs? They’re going at 5.1% right now and you can stagger the purchase so they come due every 2-4 weeks?
Also, which EAFE ETF do you use? That’s a pretty good yield!
I was going to ask the exact same thing! But actually, I haven’t needed a GIC yet, since Tangerine regularly offers me a promo rate (most recently 5%, including for USD Savings!) to move my savings back to them for several months. Moving the cash around between accounts is a bit annoying, but worth it to me for it not to be locked up in a GIC. Anyway, a guaranteed 5% (either in a GIC or Savings) seems better than 6% yield with a risk of falling capital. What am I missing?
Most of the dogmatic, JL Collins crowd of the FIRE movement will certainly turn their noses on Pref. Shares. But if you’re open to learn and recognize there’s something better than the puritan indexing investing, then you’ll find out that you don’t even need to sell a single share, just allocate some of your NW to a PFF fund will give you the piece of mind you deserve during your retirement years
“A 6% yield is usually reserved for super risky investments like junk bonds, but ZPR shares are issued by stable blue-chip companies in no danger of going into default.”
I agree with you. The yield on ZPR is very interesting. However, I think they are normal in the current interest rate environment.
For example, $HYG (High yield corporate bond ETF) has a current yield-to-maturity of 7.92%.
https://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf
Also, if you invest in the common stock instead of the preferred shares, you get even better yield and return in “relatively safe” blue chip companies. Here are the dividend yield and total return for the first four investments inside ZPR :
Royal Bank of Canada : Yield 3.93%; Return 9.33%
Enbridge : Yield 6.29%; Return 5.64%
BCE : Yield 5.78%; Return 5.55%
TD Bank : Yield 4.16%; Return 10.53%
For an average yield of 5.04% and total return of 7.76%.
(note : the return is next year’s estimated earnings divided by the share price)
My preferance still goes with equities. But if you want some kind of variable income to complement your portfolio without to much risk of loss of principal, I think ZPR is a great option. The share price could go down, but I think it’s relatively unlikely because it’s already down so much and – like you said – yield will eventually reset at a higher rate if interest rates go up.
I think tough times for investors are mostly behind us. 2022 has been insanely difficult. Even if stocks and bonds could go down more in 2023, I don’t expect it will be as bad as it was this year.
Overall, I am more positive on stocks than bonds for 2023. But I think it will be a better year for everyone. Current expected yields are much more interesting than they were a year ago !
Good article! It was a good time to buy prefs a yesr ago or so. I’ve owned a lot of BMO ZPR preferred shares ETF for 5 years in my cash account and collected $38350 in tax efficient dividend income in that time. I sold a bunch of ZPR at my cost ($10.50) 4 months ago to buy more BMO Covered Call ETF’S that pay higher dividends. Prefs are too volatile and as you pointed out no one understands why they go down at times. I may sell the rest of my ZPR this month for tax loss harvesting purposes as otherwise I will have to pay capital gains on another ETF I sold in 2022.
Waouh !
If i calculate correctly :
56358/1800000 = 3,13% Return
With actual inflation (6.9% per year, oct 2022, Statistics Canada) and without fiscal impact, your puchase power is in loss !
There’s only one thing that should dictate yours decisions : “ITP” index (in the pocket),
which is : Return less Fiscal Impact less Inflation.
Why do you want to reinvent the wheel, you have a lot of well know passive portfolio that’s work well
Personally I do not focus on dividends, but more the volarization of the asset (dividends or interests are the just the “cherry on the cake”)
We’ve been retired for just over 3 years now and have been using preferred shares as a key part of our strategy in the yield orientated portion of our portfolio. The income stability from preferreds are excellent and as you point out there are some very attractive yields in preferred stocks right now. For example, there is BCE preferred paying over 8%, numerous Brookfiled issues paying over 6% (even one near 9%) and Enbridge paying over 7%. When you consider that over the long run equities tend to return 9% on average it is hard to ignore these preferreds as they carry significantly less risk than an equity investment and are offering you an opportunity to lock in some favourable returns. During the great recession none of these quality issuers cut the dividends on their preferred shares. In fact before they can do this they would have to completely eliminate the dividend on their common shares first. As you can get these yields in from holdings in top quality companies, risk is minimizes. Additionally with the majority of fixed rate preferreds offered in Canada rates are rest every 5 years. Therefore if rates continue to go up, over time, your dividend will follow suit.
Hi !
Thanks for your article ! As a neophyte, I still have a lot to learn on the subject ! I have a question… Why preferred shares at this time and not covered calls, is one known to be “safer” ? Ex : ZPR vs ZWC. Thanks 🙂
Hi ! Thanks for your article ! I am a neophyte on the subject and was wondering.. Why preferred shares over covered calls ? Is there one that is “safer” than the other ? (Ex : ZPR vs ZWC). Thanks !!
Hi ! Thanks for your article !
I am a neophyte on the subject and was wondering… Why go for referred shares over covered calls ? Is there one that is “safer” than the other ? Or one that is better given the actual economic context ? (ex: ZPR vs ZWC) Thanks !!
Cherry picking numbers, are we?
You’re not getting something for nothing.
Consider, my friends, the Preferred and Income Securities ETF PFF, yes, it has dividend yield of 5%+.
But guess what, here is the long-term performance comparison:
PFF -37% since 2007
VTI +157% since 2007
You still want to invest in preferred shares??
Oh boy…try including the income reinvestment on this and you’ll see PFF gets very close to VTI…don’t mislead the audience with your inaccurate “analysis”
Then please care to post the actual numbers for both PFF and VTI over the long term, including dividend reinvestment (and expense ratio) for each case.
Please provide your more “accurate” analysis.
Not sure why the interest in ZPR and its other pref share equivalent ETFs.
XLB on the TSX was all the way down at around -27% a month ago from the beginning of 2022. In the the last month, it went back up more than 14% and has a current yield of 3.694%. If purchased a month ago, you’re enjoying an 18% return. As for ZPR, no bottom in its price seems to have formed on it.
And yes, I own both ZPR and XLB (11% and 18% of my portfolio respectively) although the winner for some time now has been XLB.
XLB tracks a general index fund such as VTI pretty well.
But since 2012, ZPR is down 39% !!
ZPR is not a buy and hold investment. You can hold it for certain periods of time but if a recession/market downturn is coming, it is definitely better not to be in your portfolio until that downturn has hit a significant bottom.
You mean we would need to “time” the market then?
I think of graduations of Fire like this:
-First undergrad w/ David Ransey,
-Grad w/ ChooseFI / JL Collns / M-R,
then, a post-graduation with RiskParityRadio and Big ERN
Thoughts?
… then, you have the “god mode” of FIRE, after you passed all graduations plus a few years of real-world experience w/ Warren Buffett (ie. BRK.A)
“Here’s the thing. I’ve been searching for an answer for the better part of a year now, and I still haven’t found one. Preferred shares are typically issued by stable blue-chip companies like banks, insurers, utilities, etc, and if those companies were in trouble and defaulting on their payments, that might explain the sudden drop in price. But no banks or utilities are falling over right now, so that’s not it. …The only explanation I was left with is that the price drop in preferred shares is irrational and way oversold.”
* Tell me you don’t understand preferred securities without telling me you don’t understand preferred securities. *
They are down for the exact same reason that bond funds are down: interest rates have been rising. The present value of a credit asset moves inversely to interest rates, because it’s competing with new issuance at higher rates. That isn’t some irrational market anomaly. It’s fixed income 101.
If you’ve genuinely spent a year thinking about this and don’t understand it, I am seriously concerned that you are giving anyone investment advice. Sorry if that’s harsh, but your suggestion that the price of fixed and floating-rate preferreds ought to move in opposite directions betrays a complete lack of understanding how credit markets work. Not to mention all this is information is readily available online, including in the risk section of the prospectus for one of the ETFs you are recommending: https://www.globalxetfs.com/prospectus-regulatory/?id=6024
I’m no financial advisor either but I think this may be an explanation:
https://www.investopedia.com/terms/c/callablepreferredstock.asp
Apparently some of these preferred shares are callable. If (when) interest rates go down again, the companies can call in the shares and reissue new shares that pay a lower dividend. As Bob said, to use PFF as an example, this is discussed in the prospectus under the Income Risk section as well as Preferred Stock Risk (which also discusses explicitly the Call Risk and the Tracking Error Risk). I imagine this might also contribute to increased portfolio turnover. Was this information something you’ve already considered?
You have missed out on the one Asset Class nobody has talked about in years, and its now come back big time. the GIC Ladder.
Preferred shares at 5.91 seems good, but like all dividend paying stocks, they are still volatile and can drop in a heart beat.
I am less than 2 years from FI, so stuffed a few thousand into 1 and 2 year GIC’s to create a cash cushion that will fund my retirement top up for 2 years. Now i know that money will be there, and I am geting 4.5% return, as apposed to less than 1% in T-bills. Lets see what happens in 6 months…
No way man. That high interest is a trap. Look at the long time returns. Over 10 years, both the riskier ZCN and safer ZAG funds have both outperformed ZPR despite the recent downturn. In fact, ZPR has about 0.1% return in 10 years and much higher volality than equities and bonds.
I’m wondering why you would even be considering this. As you showed in your 2021 portfolio analysis link your total annual spending is 100% covered with your current 90%/10% yield. You guys don’t have children, so no one to leave all those excess shares to. Why not just start selling off some shares to get the extra income if/when you need it? Harvesting income via dividends automatically even if you don’t need it makes no sense.
Also, dividends are just part of the total return from stocks. So you receive lower long term capital appreciation BECAUSE of the higher dividend return. If you’re well within the SWR, then increased “income” from dividends/interest is really just false security. Not worth the extra effort from a mathematical standpoint.