My Portfolio Asset Allocation – Part 3 (ZPR)

ZPR is a rate-reset preferred share ETF that is managed by BMO GAM (Please note I have no affiliation whatsoever to them, I just hold it as part of my portfolio. I just chose this one to invest in it). They define it as follows in their Fact Sheet and on their website:

The BMO Laddered Preferred Share Index ETF (ZPR) has been designed to replicate, to the extent possible, the performance of the Solactive Laddered Canadian Preferred Share Index, net of expenses. The Fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index.

The Solactive Laddered Canadian Preferred Share Index includes Canadian preferred shares that meet size, liquidity, listing and quality criteria. The Index uses a five year laddered structure where annual buckets are equal weighted while constituent securities within each bucket are market capitalization weighted.

Sometimes, the way the ETF definition provided by the ETF provider can be in plain and simple language and sometimes it isn’t and sometimes it isn’t complete. In this case, I went looking around and I found something from Horizon ETFs that at least, for me. felt a bit easier to digest (though not short and sweet). It also explains the full spectrum of preferred shares types out there and not just rate-reset preferred shares. As well, because preferred shares and preferred share ETFs are so poorly understood by the general public, I thought it would be a good thing to provide some further context.

A preferred share is a hybrid security that offers both stock and bond-like features; it provides fixed payments (like a bond) in the form of dividends, but has a share price (like a stock) that has the opportunity to rise or fall. This is why a preferred share is often considered or referred to as a “bond without a maturity date.”

In a company’s capital structure, preferred shares rank above common shares and just behind unsecured debt, which means in the event of an issuer’s bankruptcy, preferred shareholders would have a greater claim on assets than common shareholders, but a lesser claim than bond holders. Like other fixed-income securities, preferred shares are also subject to credit risk, with independent credit rating agencies assigning various levels of credit risk to issuers.

Types of Preferred Shares

Preferred shares can be structured in many ways to offer different benefits and features. Below are the four types of preferred shares:

1. Perpetual Preferreds: This type of preferred share has no maturity date and pays a fixed dividend upon issue, usually declared and paid quarterly, as long as it remains outstanding. Shareholders of perpetuals do not have voting rights and the issuers of perpetual preferred stock can typically redeem the shares.

If a perpetual preferred share is retractable, this means that the issuer can retract, or call back, the shares and decide to provide the shareholder with the issue’s value at par, payable in cash or the equivalent value in common stock. Par value refers to the predetermined face value for the redemption at the time of the original issue.

2. Floating Rate Preferreds: Sometimes referred to as a “variable rate” preferred share, this type of issue pays dividends quarterly or monthly with a rate that fluctuates, or “floats”, with a market interest rate such as a major bank’s prime rate. These types of preferreds also set a minimum dividend or “floor.” These issues typically have a set term and par value, which is repayable in cash at maturity.

If the floating rate preferred share is retractable, this means the issuer can recall the issue at any time prior to maturity in exchange for cash or equal value of the common stock. Some floating rate preferred shares can also be perpetual with no set term.

3. Convertible Preferreds: Similar to a convertible bond, a convertible preferred gives the investor the option to convert his or her holdings into some other class of shares at a fixed price on a specified date or within a specified period. Normally, the option allows for converting preferreds into the issuer’s common shares.

An investor generally pays a premium for this type of option due to the conversion terms influencing a convertible preferred’s share price, which is why a convertible preferred share will be typically priced somewhat higher than an equivalent fixed perpetual.

4. Rate-Reset Preferreds: A rate-reset preferred share offers a fixed dividend payment where the rate of that payment is reset upon a specific date, typically every five years. Generally, the rate will be a pre-determined spread above a government bond with a similar term. In Canada this is usually a five-year Government of Canada bond.

Once a rate-reset issue comes to term, the shareholder will generally have two options — hold for a new five-year fixed rate period or convert the shares to a floating rate security.

Currently, rate-resets are by far the most popular investment structure in the Canadian preferred share market, accounting for more than 60% of all available preferred shares listed in Canada.

On a risk scale, BMO GAM puts ZPR in the medium level of risk. Considering that preferred shares are something between a bond and a common stock, as well as the type of price swings it can have, that makes sense to me. 

Also, with the interest rate reseting every 5 years, when rates rise, the value “should” go up. And when rates drop, it “should” down in value. I say “should” because this type of ETF at times can fluctuate heavily and can sometimes scare investors. I’ll talk more on that when I discuss the future of this ETF later in this blog post.

Lastly, you’ll possibly hear from others out there that they don’t consider a rate reset preferred share ETF like ZPR to be a fixed income component in a B&D portfolio. The reason being that it fluctuates more like an equity than a bond. I understand their point of view however I still consider it to be part of the fixed income component of my B&D portfolio.