Many people are dividend growth investors for one big reason. They want those dividends to fund their retirement. And because all the cooooooool kids are doing it.

There are a number of reasons why this makes a ton of sense. People like the idea of spending the dividends while the capital base stays intact. One stock can always cut its dividend, but a portfolio of 30 or 50 names is pretty secure. And there are many tax advantages to limiting retirement income to dividends.

But there are also disadvantages to such a strategy. Having a portfolio of 100% stocks during retirement is risky as all hell. Most of North America’s premier dividend growers are pretty overvalued today too, suggesting they won’t do as well in the next 30 years as they did in the previous 30. And with rates so low, dividend yields kinda suck.

Instead, let me talk about a better solution.

Enter the preferred share

Preferred shares are kind of like Donny and Marie Osmond. They’re a little bit stock and a little bit bond.

Here’s how they work. A company needs cash, so they issue a preferred share. This share pays dividends, but tends to act more like debt than equity. As long as the market is convinced the underlying company can afford the dividend, they’re fine.

Preferred shares are between equity and debt on the corporate hierarchy. So if the company does run into trouble and suspends the dividend on its common shares, the preferred shareholder still gets paid. And if preferred share dividends get suspended, the company is basically bankrupt.

There are two types of preferred shares. There are perpetual preferreds, which don’t really have an expiry date. The company has the right to redeem them on a certain date at a certain price–usually par, which is $25 per share most of the time–but not the obligation to do so. There are preferred shares still floating about that have been around for 20 years. Or more. They’re like your kid who won’t leave your damn basement until they hit 35.

The other kind of preferred share is the rate reset version, which pays a fixed interest rate for five years. It then resets to a new rate, which is usually based on the Government of Canada five-year bond rate. The new rate might be the bond rate plus 2% or 3% or whatever. It depends on the credit worthiness of the company issuing the preferred in the first place.

There are many more complex details about preferred shares that we don’t need to get into right now. The point is this. If you’re looking to build an income stream using these things, you’ll want to stick with the perpetual ones.

Now the income part

Here are a few examples of perpetual preferred shares along with their yields.

  • George Weston (TSX:WN.PR.E) — 5.3%
  • Power Corporation (TSX:POW.PR.A) — 5.6%
  • Power Financial (TSX:PWF.PR.E) — 5.5%
  • Bombardier (TSX:BBD.PR.C) — 9.8%
  • Bank of Nova Scotia (TSX:BNS.PR.O) — 5.5%
  • Canadian Utilities (TSX:CU.PR.D) — 5.4%
  • E-L Financial (TSX:ELF.PR.F) — 5.5%
  • Enbridge (TSX:ENB.PR.A) — 5.5%
  • Investors Group (TSX:IGM.PR.B) — 5.9%

And so on. There are a million of these things. There are even more if you want to get a little frisky and include the floating rate ones.

With the exception of Bombardier, you’ve probably seen a pattern emerge. Most preferred shares in Canada yield between 5.5% and 6%, with most on the bottom end of the spectrum. They’re also much more boring. Take a look at the difference between George Weston common shares and the preferred shares.

wn-vs-wn-e

You might look at this chart and wonder why you’d ever own the preferred shares. Look how well the common shares did!

But the preferred shares are a whole different ball game. They’re supposed to not do much. They’re designed to protect principal, not go up.

Or buy an ETF

There are two preferred share ETFs in Canada and a few more in the U.S. The big one in Canada is the Claymore Preferred Share ETF (TSX:CPD) which has a combination of perpetual preferreds and rate-reset preferreds in it. It yields 5% on the nose.

BMO offers a laddered preferred share ETF (TSX:ZPR), which aims to limit the risk of the rate reset preferreds resetting. It has equal numbers of shares that reset in year one, year two, etc. It yields 5.05%.

What about interest rate risk?

There are two things that will cause a preferred share to crater. Either the underlying company goes all to crap or interest rates start rising.

That’s the big risk in a preferred share strategy. When rates increase, investors can get higher yields from new products. So existing preferred shares go down to compensate, boosting the yield higher.

Perpetual preferred shares are the most exposed of all to such a move. Rate-reset preferreds have interest rate protection built in. Perpetuals don’t.

There are two ways to protect yourself from interest rate risk.

The first is to commit to holding any preferred shares over the long-term no matter what the underlying price does. Remember, it’s only a loss if you sell.

You can also help protect yourself by reinvesting some of your dividends back into higher yielding shares. It’ll pale in comparison to the original investment, but at least it’s something.

Final thoughts

Preferred shares are a way for retirees to get a nice income while taking advantage of the dividend tax credit. They’re also much less volatile than regular ol’ common shares.

They’re also a decent way for younger investors to get income too. Preferred shares will never be as safe as a GIC, but they’re boring enough that I’d consider them a very decent fixed income alternative. I own a bunch of them that very quietly churn out some very predictable cash flows. You should too.

Disclosure: Nelson owns George Weston, EL Financial, and Enbridge preferred shares.

Tell everyone, yo!