In many respects, preferred shares are similar to bonds. The market timer
typically acquires long-term preferred shares if interest rates are expected to
fall and shortens the maturity of the portfolio if rates are expected to rise.
Within the preferred share portfolio, the manager regularly monitors the
relative value of available shares. If a stock is underpriced it is acquired,
and if it is overpriced it is either avoided, sold if currently held, or sold
short if the investor is particularly aggressive.
Corporate cash managers typically hold cash balances for a variety of
purposes. Generally, this cash is invested in high quality money market
securities. However, the particularities of the tax system may, under some
circumstances, make preferred shares a useful short-term investment vehicle.
In the United States, interest income is fully taxed while dividends are
partially tax-exempt. As a result, a number of corporate treasures have begun
investing cash balances in preferred shares just before the ex-dividend date and
selling the shares just following the ex-dividend date. This strategy has been
called a preferred dividend rollover. As a result, they receive the dividend
income which bears little tax, and since the share price falls after the
ex-dividend date, receive a deductible capital loss.
The preferred dividend rollover presents a variety of risks not present in
most money market securities. First, if the preferred share has a long period
until redemption, the investor takes on substantial interest rate risk. Second,
the risk of default and the exposure on default is usually greater for preferred
shares. Third, there is often a possibility that, even if default doesn't occur,
the issuer may decide to defer payment of the dividend.
Preferred share funds
For the investor with a modest amount of money to invest and the desire to
diversify, a number of preferred share mutual funds are available.
