When most of us talk about “stocks,” what we’re really referring to is common shares, an investment that involves buying a share of ownership in a business, and then (hopefully) sharing in the profits of that business, along with all the other shareholders. But there’s another option that’s often overlooked by most investors: preferred shares. Like common shares, preferred shares are also a form of equity in a company; but in practice, they behave much more like very long-term bonds than like ordinary stocks. They do have some obvious flaws. For one thing, they’re issued with a set dividend, which doesn’t increase if the company performs better than expected. For another, some classes of preferred shares, known as “perpetual,” have no maturity date—meaning that investors can be locked into the set yield for a long time if share prices fall.

Despite these apparent shortfalls, though, preferred shares are getting a second look nowadays from investors hit hard by the decline in common stocks. The big market drop of October 2008 dragged down just about every asset class, with the exception of government bonds and cash-equivalent investments such as treasury bills and money market funds. Preferred shares took a beating too, declining as fears of further financial catastrophe rose.

That’s unusual behaviour for this asset class. In a normal market, preferred shares typically decline when interest rates go up, and rise when interest rates go down. That’s because they normally trade based on their yield relative to the current interest rate environment. But now, preferred shares are suffering from investor fears that banks might default. Instead of going up in response to declining interest rates, as usual, the value of preferred shares has actually fallen.

For income-oriented investors, this may represent an opportunity. Right now, many such investors are caught between a rock and a hard place: they want to convert their growth investments to income, but they’re nervous about doing it at such low market levels. It doesn’t make sense to switch to a GIC after a 40% plunge in the stock market, yet they need the income to support their lifestyles.

Preferred shares can look like a smart option for investors with strong nerves. Because the income is high, and the shares are depressed, a return to normal credit markets would mean both high current income and an increase in the price of preferred shares. In many cases, preferred shares are trading at a 40% discount to where they were before the market took its October plunge.

Consider this example: a $25 Manulife perpetual preferred share issued in January 2006, with a dividend of $1.10 per share, is currently trading at $18. At that share price, the up-front yield is over 6%; and as a Canadian dividend, it also receives a favourable tax rate. (If, instead, you earned interest on an investment, you’d have to earn over 8.5% to keep the same after-tax amount). Another bonus: in the event of a company meltdown, preferred share dividends normally don’t get cut until after the common stock dividends are eliminated. That makes your income more secure.

Considering all these advantages and disadvantages, you can see that preferred shares aren’t for everyone. Their long-term nature and their interest-rate volatility mean that their prices can and do move around to an often nerve-racking degree. But for income investors wondering whether their stocks will ever come back, switching to preferred shares may just be a valid strategy to get dividend income today, without giving up the prospect of a capital recovery tomorrow.

Alan MacDonald is an Investment Advisor with Richardson Partner Financial Ltd. Alan helps investors with over $500,000 of assets make smart decisions about money. For more information please visit alanmacdonald.ca or e-mail Alan at Alan.Macdonald@RichardsonGMP.com.

Richardson Partners Financial Limited is a member of CIPF.