The Yield Shield: Preferred Shares

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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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

  1. Swinging your overall equity allocation towards fixed income. 60/40 is the balance we chose.
  2. 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.

Different Types

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:

  1. Perpetuals. These pay a fixed rate dividend that never changes.
  2. 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%.
  3. 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:

  1. Increasing your Portfolio’s income since you’re replacing bonds yielding 2% with Preferreds yielding 4-5%
  2. Increasing your Portfolio’s volatility since Preferreds are riskier
  3. 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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41 thoughts on “The Yield Shield: Preferred Shares”

  1. Hi Wanderer,

    Thanks a lot for this post, I had no idea Preferred Shares were a thing. Seems like a very powerful tool for retirement, especially considering the current yield on bonds.

    Keep up with the good stuff and enjoy your retirement!

  2. Thanks for this post. I am still somewhat of an investing novice. I prefer the 3 fund lazy asset allocation, but since I’m still in the work force my need for a yield shield is minimized. If you are retiring ultra early or cutting the numbers close, I think your technique makes a good deal of sense.

    1. Yeah that makes sense. You don’t need to own any until you actually pull the trigger. Keep it simple in accumulation phase and just concentrate on controlling your spending.

  3. I was waiting for this post since last month when the interest rates started hiking. As a matter of fact my TFSA 2018 contribution in cash account and waiting for the suggestion/recommendation on preferred shares.

    My situation is, i am into FIRE about 5 years from now and currently at 60E/40B. As i am in accumulation phase for another 5 years and don’t need yield shield for now,
    is it still worth to buy CPD (20% out of 40% of by fixed income portfolio) ?

    As the interest rates are going to be increased further, wont the VAB yield going to improve despite the value might decrease ?

    Last question, if i have to replace 20% of my portfolio with high yielding assets? do you suggest diversify with other assets like REIT or straight CPD ?
    Once again thank you for yet another great post, still financial dummies like me struggling to understand some of these basic concepts that too with time to time changes in the market.

    1. I wouldn’t bother with higher yielding stuff now. Maybe a year away from retirement.

      And as interest rates increase, VAB’s price will go down and the yield will go up, but that’s for new money going in. One way of managing this is to shorten your bond duration in a rising interest rate environment and then lengthening it as rates peak. This will be an upcoming post.

      And Preferreds are just one asset class you can use to increase your yield. I’ll be talking about the other types like REITs over the next few weeks.

  4. Two questions:

    Q1: iShares CPD lists an MER of 0.51% and a Management Fee of 0.45%. Don’t you have to add those two up for a total cost of 0.96%?

    Q2: Is there a difference between a preferred share ETF and a high dividend yield ETF?

  5. i’ve owned pff for about 3 years now in a large amount at around 10% or our portfolio. we’re still working but i’m using it as a fixed income ballast for the boat. i like the fact they pay out monthly and the yield (net of fees) is a healthy 5.6% but the etf price tends to go down as interest rates rise and bonds start to look more attractive in comparison. that’s fine as long as you don’t have to sell. the other downside i have noticed is the monthly dividend is not constant for the etf (it is constant for the individual shares) as shares can be retired or recalled and the mix changes. for instance, the payout for december 1 was 0.192/sh and the payout for march 1 was 0.172. that’s 10.4% less income 3 months later. the payouts for the past 5 years are available on yahoo finance. i’ll continue to own them but recently swapped 30% of them out for even higher yield of a closed end fund (JPS) of preferred’s. i also bought a taxable one with a higher yield called SPXX. there’s a little food for thought or further research if you’re a money nerd like me.

    1. Yeah imagine how much fun that would be if you owned individual preferreds. I briefly owned individual preferreds for income, and then one would get redeemed and I’d be like “GODDAMMIT that was 20% of my preferred allocation!”

      Eventually I was like “screw it, just index”

      1. i agree and that’s why i’m in the etf boat. even a 10% payout haircut in the short term is pretty good considering it was being cut from an already high rate with all the diversification built in. rock on!

  6. PFF ETF just spiked today and I think it was thanks to you guys!!! Great Post!

    I noticed that PFF dropped from $51 a share to $14 a share in 2009. This behavior is exactly like common stocks so…careful there!

    1. Yup. When companies start falling over these higher yielding assets get hammered so you lose some of the volatility balancing effects of fixed income. Again, this isn’t something I’d own long term, just for the Yield Shield-dependent part of my retirement.

  7. i have CPD and ZPR and XPF

    isn’t ZPR better in a rising rate environment ??

    which is a an extra bonus as equities don’t like rising rates

    you only hold one ETF ( CPD) . .. why not more like me to spread the risk ??

    thanks

    1. I don’t know much about those, but they seem fine at first glance. And I don’t think it makes sense to “spread the risk” when you’re talking about index funds. 3 index funds that track the same index is pointless.

      1. Garth recommends Fixed Rate Resets due to the rising rate times we are moving into

        and ZPR is full of them compared to CPD ..

  8. Well, this is something new. You guys are always on the forefront of knowledge! Could preferred shares take the place of regular shares, I wonder? Some of the yields seem quite lucrative.

    1. No way. Preferred shares are riskier fixed income, not equity. They don’t participate in the continuing expansion of the global economy like equities do and they don’t act as an inflation hedge. Long-term growth comes from equity.

      1. So are the returns. 14% yield I could afford to pay 1.75% in MER right?
        I’ll be waiting on a post stating the pros and cons about investing in CEFs

  9. It’s interesting to me that owning preferreds seems to be quite a bit more acceptable for individual Canadians as an investment option than for Americans. I know almost no American individual investors dabbling in this area. (U.S. corporations have a tax incentive to own preferreds.)

    I respect your approach, but it seems you are injecting additional equity-like volatility into your portfolio with preferreds while giving up equity like potential upside over the long-term. Take a look at the charts of major preferred ETFs through the financial crisis. Not anything like a bond…..

    I’m going to give this some additional thought as I generally like your take on asset allocation as I’ve commented before. Cheers!

    1. I wouldn’t go so far as to call it equity-like but I am adding volatility to my fixed income allocation to increase my portfolio yield. I am planning on using this in conjunction with my Cash Cushion to protect me from an inconvenient market crash in the first few years of my retirement. Once this risk abates, I will exit these positions and return to a more traditional fixed income allocation.

      1. If you go to Yahoo finance and pull up a chart comparing the performance of SPY (the S&P 500 tracker ETF) and PFF (one of the most popular preferred ETFs) from Jan 1, 2008, to Jan 1, 2010, you will see that PFF was actually more volatile than the S&P 500 through that period. And, PFF has not come close to getting back to its pre-crisis highs.

        But I won’t belabor this further! 😉

  10. MY “yield Shield” is holding higher percentage of Australian shares then world as they pay higher dividend 5-6% including franking.

    Planning on 50-50 mix

  11. Amazing article, I’ve always seen the term Preferred Shared but never quite understood what that meant. I thought they were just shares from a “selection” of high yield dividend issuing companies. Thanks for explaining it clearly 🙂

    P.S. it’s so disturbing to see “it’s” used multiple times where “its” was needed 😛

  12. Nice post, Wanderer. I’ve been doing research on these myself, so it was timely. I’m still undecided on this. I think in this case perhaps a non-index makes more sense, if you have time the knowledge to research and understand. But as you point out, things like this can reduce your sequence of returns risk, which I’m very interested in during this point in time. Wander on!

    1. I tried to own individual preferreds myself and even I got confused. You have to pore over the prospectus of each individual issue, and eventually I was like “Fuck it. Just index.”

  13. I know corporate bonds might be similar but I just feel like preferred shares seem risky from a diversification standpoint. At some point, I calculated the actual complaints from one of the Canadian preferred ETFs and it was under 40 I think.

    I guess I just can’t wrap my head in putting 20% of my portfolio in such a small amount of companies. I get that they will be paid out before common shares. Fundamentally, it just seems to contradict the principle of using broad based indexes.

    Any way to counteract that?

  14. Hi.
    How did you feel when at the end of the month, after a huge sacrifice at work giving basically your blood to get paid you add it all on your investment account asset allocation defined only to see the market wipe it out and more in a single day ?
    When that happens I feel like wd everything and putting under a mattress ! How do/did you deal with that when you’re working?

  15. So, do you guys have a lot of Cum–Okay, okay, I’m leaving!

    Interesting article about preferred shares. I never really cared for them because I always felt that they were a way too complicated way to own a company. I still do. I’d rather just own a piece of a business than figure out these complicated securities. I also don’t worry about volatility, but that’s because I’m a dividend investor before all else.

    For safe, high yielding instruments, what do you think about municipal bonds?

    Sincerely,
    ARB–Angry Retail Banker

  16. Wanderer, you suggest you will take this Preferred Shares approach for the first several years and then move back into more traditional Fixed Income products. Have you considered that if we have a repeat of 2008/09 before you exit the Preferred Shares strategy that your principle could be severely impacted, resulting in a net loss?

    Like some others who have commented, I am struggling with the extra risk, given the current market (9+ years of a Bull market). I am curious if you subscribe to a lower or higher market over the next 3-5 years? Your model is fundamentally sound but not sure it factors in the risk that you are accepting and comparing that to preserving your capital in a CD (or Bond ETF i.e. MINC, MINT) and getting a 2-3% return and then shifting the principle into equity when the market cycle completes (after the downturn). Although this may be construed as timing the market, I would suggest it is assessing the market for what it is and what it is not, at this point in time. Also not sure you consider inflation into the analysis, which is sure to put downward pressure on the price of the index. Interested in your thoughts on these topics.

  17. I’d love to hear everyone’s thoughts on VanEck Vectors Preferred Securities ex Financials ETF, PFXF. It’s got a SEC yield of 6.14% (and has averaged 6.1% since 2012) and this is after the 0.46% expenses are taken out. I like it better than iShares PFF because it isn’t so concentrated (71%) in Financials, in fact it doesn’t have them at all. Finally, it’s trading almost exactly at it’s NAV where PFF is trading at a 32% premium – that feels a lot like the “buy high” no no. I found it through this article:

    https://www.kiplinger.com/slideshow/investing/T018-S001-10-preferred-stock-funds-safe-substantial-yields/index.html

    …where Kiplinger says: “As the somewhat cumbersome name implies, this fund invests in preferred stocks of companies outside of the financial space.

    There technically is a little financial-sector exposure via a 5% investment in insurance companies. But otherwise, PFXF lives up to its name, investing heavily in preferreds from real estate investment trusts (REITs, at 30% of net assets), electric utilities (25%) and telecoms (14%).

    PFXF also sports lower credit quality than the previously mentioned pair of ETFs. Only 45% of the portfolio is invested in investment-grade preferreds (and most of that is in BBB-rated), with 16% dedicated to “junk”-rated preferreds, and 39% that aren’t rated at all.

    However, the strategy typically results in one of the biggest yields among preferred-stock ETFs, and its lower-than-average 0.41% expense means you get to keep more of the fund’s returns.”

    The lower credit rating of it’s investments than PFF is a concern, but that yield of 6.1% has been rock steady since 2012 which makes me feel somewhat better.

    Your thoughts?

  18. I am enjoying your yield shield series … … on a side note … in Canada one needs to work and contribute taxes a minimum of 15 years I believe to get a national and provincial pension … so this would maybe affect early retirees and long term non resident overseas workers … we would need to be self sustaining without any hope of additional government pension money at 65ish … in the States it is similar? …. is that correct as you see it?

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