10.6 Assessing Preferred Share Investment Quality

Preferred shares sit between bonds and common shares, so judging their safety combines bond-style credit analysis with equity features. Because a company can skip preferred dividends without defaulting, investors need evidence that dividends are well covered and that the shares are protected if the company fails.

Earnings Coverage

Preferred dividends are paid from after-tax income, while interest is paid from pre-tax income. To compare them on the same basis, analysts gross up preferred dividends to a pre-tax amount.

$\text{Combined coverage} = \frac{\text{EBIT}}{\text{Interest} + \dfrac{\text{Preferred dividends}}{1 - t}}$

A simpler after-tax measure is:

$\text{Preferred dividend coverage} = \frac{\text{Net income}}{\text{Preferred dividends}}$

The combined measure is more conservative because it recognizes that bond interest must be paid first. Analysts look at the trend over several years, especially through a recession.

Asset Coverage

Asset coverage asks how much would be left to repay the preferred shareholders if the company were wound up, after creditors were paid.

$\text{Asset coverage per preferred share} = \frac{\text{Total assets} - \text{Intangibles} - \text{Current liabilities} - \text{Long-term debt}}{\text{Number of preferred shares}}$

Comparing this amount with the preferred's par value (or dividing net assets by the total par value of the preferreds) shows how many times the preferred claim is covered. Analysts also calculate equity per preferred share (total shareholders' equity ÷ number of preferred shares) as a simple cushion measure.

Worked Example

Northern Utilities Ltd. reports (in millions):

1. Combined coverage: $120 / [20 + 15 / (1 - 0.25)] = 120 / (20 + 20) = 3.0$ times.
2. After-tax dividend coverage: net income = $(120 - 20) \times (1 - 0.25) = 75$; $75 / 15 = 5.0$ times.
3. Asset coverage: $900 - 50 - 150 - 300 = 400$ million of net tangible assets; $400 / 6 = 66.67$ dollars per preferred share, or $400 / 150 = 2.67$ times the preferreds' par value.
4. Equity per preferred share: total equity $= 900 - 150 - 300 = 450$ million; $450 / 6 = 75$ dollars per share.

Earnings cover the combined fixed charges three times, and tangible assets cover the preferred claim more than two and a half times, which suggests reasonable quality. A sharp fall in EBIT would cut the combined coverage quickly, so stability of earnings matters as much as the level.

Preferred Share Ratings

Credit rating agencies rate preferred shares on their own scales:

Each category may carry "high" or "low". Pfd-3 and above are generally viewed as investment grade. S&P uses a similar Canadian preferred scale (P-1 to P-5). A company's preferred shares are rated lower than its senior debt because they rank behind it.

Qualitative Factors

• Cumulative vs. non-cumulative: cumulative dividends are safer for the holder.
• Industry and size: large issuers in stable, regulated industries (banks, utilities, pipelines) usually have steadier coverage.
• Dividend record: a long history of uninterrupted payments.
• Features: a retraction right protects capital; a call feature limits upside; a rate reset with a high spread protects income when rates rise; a low reset spread or a floor matters when rates fall.
• Liquidity: small issues can be hard to sell without a price concession.

Because preferred prices also move with interest rates, a high-quality perpetual preferred can still lose value when yields rise. Quality analysis addresses default risk, not interest rate risk.

Preferred Shares vs. Bonds of the Same Issuer

Because preferred shareholders rank behind every creditor, a company's preferred shares are always riskier than its bonds. Individual investors are compensated partly through the dividend tax credit, which can make a lower pre-tax preferred yield competitive with a higher bond yield.

Worked Example: Comparing After-Tax Yields

Assume an investor's marginal tax rate is 43% on interest and 25% on eligible dividends.

• A bond yielding 5.5% leaves $5.5\% \times (1 - 0.43) = 3.14\%$ after tax.
• A preferred share yielding 5.0% leaves $5.0\% \times (1 - 0.25) = 3.75\%$ after tax.

Despite its lower stated yield, the preferred share pays more after tax. That advantage is the reward for accepting a junior claim, so the analysis of coverage, ratings and features above is what tells the investor whether the extra income is worth the extra risk. The comparison does not apply inside an RRSP or TFSA, where the dividend tax credit is lost.