While they promise higher yields and tax advantages, preferred shares carry asymmetric risks that often make them unsuitable for the average investor.

The Illusion of Exclusivity

Alternative investments are frequently sold on the basis of exclusivity, targeting wealthy individuals and institutional funds who feel they deserve something beyond the standard market return. As Warren Buffett noted in his 2016 letter to shareholders, human behavior rarely changes; pension funds and endowments will always seek out "something extra" in their investment advice. This desire for the niche often leads investors toward high-yield bonds and preferred shares.

Preferred shares are particularly seductive to income-oriented investors because they typically offer higher yields than traditional bonds. In certain jurisdictions, like Canada, they also come with tax benefits that make them appear superior to interest-bearing debt. However, these benefits are not a free lunch. In the world of finance, risk and return are inextricably linked, and the complexity of preferred shares hides a variety of traps that can catch an unwary investor off guard.

Neither Debt Nor Equity

To understand the danger of preferred shares, one must understand where they sit in a company's capital structure. They are equity investments in the sense that they are subordinate to bondholders. In the event of a bankruptcy, debt holders are paid first. Preferred shareholders follow, and common stockholders are last. In practice, by the time a company reaches liquidation, there is rarely anything left for anyone but the bondholders. Preferred shareholders usually receive nothing.

Despite carrying this equity-like risk, preferred shares do not offer equity-like rewards. Unlike common stock, preferred shares do not participate in the growth of the company. Your return is almost entirely capped at the fixed dividend. You are essentially taking on the risk of a business owner without the possibility of participating in the upside if the company triples in value. This creates a fundamental imbalance in the investment's value proposition.

The Problem of Perpetual Duration

One of the most significant risks of preferred shares is that they generally do not have a maturity date. This makes them effectively like extremely long-term bonds. While a ten-year bond has a clear end date where you expect your principal back, a perpetual preferred share requires you to trust the issuing company’s creditworthiness for the next fifty years or more. This exposes the investor to an immense amount of long-term credit risk.

Furthermore, the lack of maturity makes these shares highly sensitive to interest rate fluctuations. While a drop in interest rates should theoretically increase the price of a perpetual share, most issues include a "call feature." If rates fall significantly, or if the company’s credit rating improves, the issuer will simply redeem the shares at the original issue price and refinance at a lower rate. This creates an asymmetric risk profile: if rates go up, the value of your shares crashes; if rates go down, the company takes the shares back, and your upside is capped.

Structural Volatility and Reset Risks

In markets like Canada, "fixed reset" preferred shares are common. These attempt to mitigate interest rate risk by resetting the dividend every five years based on government bond yields plus a spread. While this sounds like a safeguard, it does not eliminate volatility. In 2015, for example, the S&P/TSX Preferred Share Index fell by 20 percent in just nine months. Even with reset mechanisms, these instruments can behave unpredictably during periods of market stress.

Investors should also consider why a company issues preferred shares in the first place. Often, a company turns to the preferred market because it cannot afford to take on more traditional debt without triggering a credit downgrade. Furthermore, companies can suspend preferred dividends at their own discretion without the dire legal consequences of missing a bond payment. A bond default leads to bankruptcy; a preferred dividend suspension is merely a corporate choice. This makes preferred dividends far less secure than the interest payments on a bond.

A Narrow Path for Inclusion

If preferred shares are so fraught with complexity, why do they exist in any portfolio? The primary argument is diversification and tax efficiency. Because their returns are not perfectly correlated with other asset classes, they can provide a slight diversification benefit. For high-earning Canadian investors in taxable accounts, the dividend tax credit can also make the after-tax yield more attractive than that of corporate bonds.

However, these advantages are narrow. If you choose to invest in this space, it should be done with extreme caution. It is generally advisable to limit preferred shares to between five and fifteen percent of a total portfolio and to hold them only in taxable accounts. Most importantly, individual preferred shares are too complex for most people to analyze properly. If you must own them, use a broadly diversified, low-cost ETF to mitigate the risk of any single company failing. For most investors, however, the simplest path is to avoid them entirely and stick to the clearer risks of common stocks and high-quality bonds.