Preferred dividends: an alternative to interest income: preferred stocks are becoming more attractive than bonds for fixed income investors

Money Digest, Dec, 1996 by Kerene Harvey

With interest rates continuing to decline many investors in fixed income securities are finding that their income is also falling as investments mature and the proceeds must be invested at much lower interest rates. One strategy, for some investors with taxable accounts, would be to diversify some of their assets into preferred shares.

Term preferred shares (preferred shares which are redeemable at a stated price and time) are entitled to a preset rate of dividend. In most cases this dividend is much higher than the dividend being paid on the common shares. Preferred dividends are paid out of the company's earnings before any dividends are distributed to the common shareholders. Like bonds preferred shares are rated by the major credit rating services such as CBRS and DBRS so that investors have a yardstick by which to gauge the credit worthiness of the shares.

Preferred share dividends are eligible for the Canadian dividend tax credit so they receive more favourable tax treatment than interest income. The calculation of taxes on dividend income consists of grossing up the income by 25%, calculating the Federal Tax payable and then deducting a tax credit of 13 1/3% of the grosed-up amount. Provincial tax is then calculated on this amount.

As a result of this calculation the after tax retention rate is greater for dividend income than for interest income. Some investors might therefore benefit from receiving some of their income in the form of preferred dividends.