When you pull the trigger and retire, the biggest danger you need to worry about is a sudden market crash right in your first few years that forces you to sell assets at the exact wrong time. This is known as sequence of return risk, and we’ve written in the past about our method of hedging this risk: Building a Yield Shield and keeping a Cash Cushion. Today we’re going to talk about how we actually did that.
To recap, building a Yield Shield means
- Swinging your overall equity allocation towards fixed income. 60/40 is the balance we chose.
- Shifting your fixed income portion towards higher yielding assets.
When you’re accumulating, bonds’ job is to reduce portfolio volatility because they tend to move in opposite directions with equities. However, with interest rates so low, as an income-producing asset, they don’t pay too well. As of the time of this writing, the Canadian Vanguard Bond ETF VAB has a 12-month trailing yield of 2.8%. Not only that, with interest rates on the rise, we can expect bond prices to get lower over time, which double-sucks. So what should we use instead?
Today, I’m going to talk about one of the higher-yielding assets we use in our retirement portfolio: Preferred Shares.
What is a Preferred Share?
A Preferred Share is kind of a mix between a stock and a bond. They’re technically shares that get traded on the stock exchange like other shares, but they don’t give you any ownership or voting rights of the company. They also pay you a dividend like common shares that are eligible dividend income, so their dividends are tax-efficient. But while the common shares pay dividends in the 1-2% range, Preferred Shares can pay upwards of 5%.
Companies issue these to raise money, and because Preferred Shares don’t give you any ownership in the company, the usual behavior of shares don’t apply. If a company does great, it’s common shares will rally, but generally their Preferreds don’t move. But if interest rates change, that can swing the price of Preferreds, so despite the name, they really act more like bonds than shares.
The name comes from the rules concerning the order in which a company must pay their debts. If a company has a bad quarter and decides to cut their dividend, they have to cut dividends on their common shares first. Preferred Shares’ dividends are protected, or “Preferred,” if you will.
Preferred Shares are also more complicated than common shares. Each issue has it’s own different set of rules, so even two different issues of Preferreds from the same company may have wildly different behaviors, which is why each issue trades under a different symbol on the market. Here’s TD Bank’s Preferred Share issue, which they label as “Class A Preferred Shares, Series Q” and trades under the symbol TD.PRQ.CA.
Generally, there are three different types of Preferred Shares:
- Perpetuals. These pay a fixed rate dividend that never changes.
- Floaters. Floating Preferreds pay a dividend rate that’s pegged as a premium to interest rates. So if a Floater is issued at a 3% premium and current interest rates are at 2%, then the Preferred would pay 5%.
- Fixed Rate Resets. These are hybrids of the above two. They pay a fixed rate for 5 years, and then reset based on interest rates like Floaters.
Why is this important? Perpetuals are more like traditional bonds and will go up in price if interest rates drop. Conversely, they will go down in price if interest rates rise. Floaters and Fixed Rate Resets will do the opposite. They will do well in a rising interest rate environment, and do worse in a falling one.
You Can Index Them Too!
This is a very broad overview of the types of Preferred Shares. Besides these 3 types, there are all sorts of other things that are unique to each issuance. They can be Cumulative or Non-Cumulative (hilariously labelled as Cum and Non-Cum). They can be convertible to common shares. They can be redeemable by the issuer. It gets super complicated, so for that reason we don’t recommend you own any Preferred Shares directly. Instead, use broad-based ETFs.
In America, the biggest ETF is the iShares U.S. Preferred Stock ETF named PFF, but there are a few others, including ones that deliberately bias towards Fixed or Floating issuers.
|Name||Ticker||Current Yield||MER||Type of Share|
|iShares U.S. Preferred Stock ETF||PFF||5.5%||0.47%||Both|
|PowerShares Preferred Portfolio||PGX||5.66%||0.51%||Fixed|
|PowerShares Variable Rate Preferred Portfolio||VRP||3.95%||0.5%||Floaters|
Note that I don’t own any of these myself (since I’m not American and that wouldn’t make sense), nor am I recommending them. These are provided for your information only. Do your own research!
In Canada, there are less choices of Preferred Share ETFs, but the one we used when we retired is called the iShares S&P/TSX Canadian Preferred Share Index ETF. It’s currently yielding 4.4% with an MER of 0.5%, and has about a 2/3 allocation towards Floaters.
Anyway, a couple things to notice here: These higher-yielding assets generally have higher MERs. This is because these ETFs aren’t nearly as big as our traditional Index ETFs, so they don’t have the same economies of scale that VTI does. And second, these are riskier assets than bonds. Bonds are tied to the government, while these are tied to a company, so if an individual company fails, its Preferred Share may go poof. That being said, we are indexing here, so it’s impossible for the ETF to go to zero, but it may decline if a bunch of their Preferreds start defaulting.
How Do These Fit Into My Portfolio?
When you retire, you basically take a portion of your bond allocation and swap it for Preferreds. For us, we decided to swap out about half of our bonds, so we currently have a 20% allocation towards Preferred Shares. How much you choose to swap is up to you, but this has the effect of:
- Increasing your Portfolio’s income since you’re replacing bonds yielding 2% with Preferreds yielding 4-5%
- Increasing your Portfolio’s volatility since Preferreds are riskier
- Increasing your Portfolio’s average MER since Preferreds have a slightly higher cost
And yes, this does make your portfolio more volatile, but if it increases your yield, and you use that yield in conjunction with your Cash Cushion to not have to withdraw during market downturns, that’s a good trade-off during the first few years of early retirement.
And again, note that this is meant to be a temporary change to guard against Sequence-of-Return-Risks. As we wrote about here (How We Plan to Change Our Equity Allocation in Retirement), our longer term plan as our portfolio grows (and our dependence on our Yield Shield decreases) is to exit these positions and pivot back towards a normal bond ETF for this part of our portfolio, and then over time to increase our equity allocation altogether.
So that’s Preferred Shares. Preferreds is just one of the tools we use to create our Yield Shield, and we will talk about the others every Wednesday for the next few weeks.
Questions? Comments? Let’s hear them in the comments below!
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