8.2.4 Risks and Considerations

8.2.4 Risks and Considerations

Introduction

Preferred shares, as a hybrid security, offer a blend of features found in both equity and fixed income products. They often draw interest from investors seeking a stable income via dividend payments, combined with a higher claim on assets than common shareholders in the event of liquidation. However, it’s crucial for investors to be aware of associated risks, particularly interest rate sensitivity and credit risk.

Interest Rate Sensitivity

Preferred shares are particularly sensitive to changes in interest rates due to their fixed dividend returns, similar to bonds. When interest rates rise, the fixed dividend provided by existing preferred shares becomes less attractive compared to the yields on newly issued shares or debt instruments. This leads to a decrease in the market price of existing preferred shares. Conversely, when interest rates fall, preferred shares can become more attractive, potentially increasing their market price.

The effect of interest rate changes on preferred shares can be illustrated through the bond yield behavior model:

    graph TB
	    A(Interest Rates Rise) --> B(Present Value of Fixed Dividends Falls)
	    B --> C(Market Price of Preferred Shares Falls)
	    
	    A1(Interest Rates Fall) --> B1(Present Value of Fixed Dividends Rises)
	    B1 --> C1(Market Price of Preferred Shares Rises)

In this model, as interest rates rise (A), the present value of fixed dividends falls (B), resulting in a decline in the market price of preferred shares (C). The opposite cycle occurs when interest rates fall.

Credit Risk

Credit risk pertains to the issuer’s ability to maintain dividend payments and redeem the principal invested in preferred shares. Unlike bonds, preferred shareholders typically must rely on the issuer’s ongoing financial health as there might be no fixed repayment date.

In times of financial turmoil or poor creditworthiness, issuers might defer or reduce dividend payments. This risk is comparable to default risk in bonds but is additionally critical for preferred shares because they do not benefit from the same legal protections or priority claims as bonds in an issuer’s debt structure.

Understanding credit ratings is vital for assessing credit risk. Issuers with higher credit ratings are deemed more reliable and less likely to default on preferred share dividends. Conversely, lower credit ratings suggest a higher risk of default, prompting investors to demand higher yields as compensation for the increased risk.

Comprehensive Analysis Diagram

    graph TD
	    D(Features of Preferred Shares) --> F(Interest Rate Sensitivity)
	    D --> G(Credit Risk)
	    
	    F --> H(Impact on Market Price)
	    F --> I(Yield Comparison with New Issues)
	    
	    G --> J(Dividend Payment Reliability)
	    G --> K(Issuer's Financial Health)
	    
	    J --> L(Credit Ratings Impact)
	    K --> M(Default Risk Indicator)

In this diagram, the features of preferred shares (D) expand into interest rate sensitivity (F) and credit risk (G). These branches delve into their respective impacts — on market price and yield comparisons for interest rate sensitivity, and on dividend payment reliability and issuer financial health for credit risk.

Glossary

• Preferred Shares: A class of ownership in a corporation with a higher claim on assets and earnings than common shares.
• Interest Rate Sensitivity: The responsiveness of a security’s price to changes in interest rates.
• Credit Risk: The risk of a loss stemming from an issuer’s failure to make payments as promised.
• Credit Ratings: Evaluations provided by credit agencies assessing an issuer’s creditworthiness.

Additional Resources

• Investment Industry Regulatory Organization of Canada (IIROC)
• Canadian Securities Administrators (CSA)
• Standard & Poor’s Credit Ratings

Summary

Investing in preferred shares requires a careful consideration of various risks, primarily interest rate sensitivity and credit risk. Changing interest rates can significantly affect the price of preferred shares, while issuer credit vulnerabilities can impact dividend reliability. Investors must weigh these factors to make informed investment decisions that align with their financial goals and risk tolerance. Ensuring a robust understanding of these dynamics is crucial for leveraging the benefits of preferred shares within a diversified investment portfolio.