Income-seeking investors who don’t like the minuscule after-tax returns from bonds yet fear the volatility of common shares have a third option that looks most attractive: preferred shares.

Preferred shareholders, as the name implies, rank ahead of common shareholders if a company runs into trouble. Preferred shares pay dividends, which are taxed more favourably than interest, so the after-tax returns beat those from corporate bonds over most periods, research by James Hymas, president of Hymas Investment Management and an expert on preferred shares, shows.

During the bear market that crushed common shares between 2007 and 2009, a diversified portfolio of TSX-listed preferred shares would still have been able to deliver a positive five-year return, Mr. Hymas said. “Many investors panicked during the crash of this market during the Credit Crunch — but others simply continued to cash their regular fixed dividend cheques.”

Some preferred shares can be “called” or redeemed by the issuing company, usually five years after the stock was issued, with the shareholder gradually getting less the longer he owns the shares. Others allow the investor to retract, or redeem in reverse — forcing the company to buy back shares.

The call provisions and other features may cause investors to shun preferreds as being too complex, but corporate bonds also have call provisions. “Perhaps most rationally, preferred shares are generally comparable to long-term corporate bonds and there are many people who, for good reasons or bad, prefer short-term fixed-income investments,” Mr. Hymas said.

Preferred shares are not as liquid as common shares, and some preferreds are so thinly traded you will have to wait to buy more than 100 of them at a time. The BMO Investorline stock screener lists 318 Canadian preferred share issues but only 53 of these — about 17% — have intraday trading volumes of more than 10,000 shares. By comparison, 66% of common share issues have intraday volumes of more than 10,000 shares.

The spread on preferred shares — the difference between the quoted bid and offer — is sometimes more than 25¢, Mr. Hymas said. “It may not sound like much, but even 10¢ is a month’s worth of dividends.”

The wide bid-ask spread means investors should never buy preferreds using a market order, he said. “There is always the chance that the quote you thought you saw will disappear while you’re pressing the ‘enter’ button.”

Mr. Hymas’s Malachite Aggressive Preferred Fund (named after a green stone that is carved into vases and jewellery) has delivered superb returns. Over the year to Sept. 28, for example, the fund is up 12.66%, while the return on the Bank of Montreal’s Nesbit Burns NB-50 Index of preferred shares was just 6.45%.

Those who want to invest in his fund generally must be accredited investors — people whose joint assets exceed $1-million or whose annual income is at least $200,000 — and must invest at least $50,000 in the fund. If you don’t qualify as an accredited investor, the minimum investment is $150,000.

Another way to invest in Canadian preferred shares is through exchange-traded funds, all of which pay monthly distributions that provide a yield of about 5%:

— The iShares S&P/TSX Canadian Preferred Share Index Fund (CPD/TSX), renamed after Blackrock absorbed the Claymore funds earlier this year, has a 0.5% management expense ratio. This fund held 144 issues at the end of June, with the top 10 each accounting for about 1% of the fund.

— The Horizons Preferred Share ETF (HPR/TSX), launched in 2010, is actively managed by subadvisor Fiera Capital, and has a much more concentrated set of holdings than the iShares fund and a slightly higher MER of 0.55%.

— Invesco’s PowerShares Canada Preferred Share Index ETF (PPS/TSX), launched last year, has a portfolio of 50 preferreds that is less concentrated than the Horizons fund, but not as broad as the iShares ETF. Its MER is 0.45%.

Here are some U.S. ETFs for non-taxable accounts:

— The iShares S&P U.S. Preferred Stock Index Fund (PFF/NYSE) has a 0.48% MER and yields 6.38%, paid monthly. Its major holdings include the preferred shares of several financials, such as HSBC Holdings PLC, Barclays Bank PLC and ING Groep NV, and General Motors Co.

— A competing ETF, the tiny US$287-million Wells Fargo Preferred Stock ETF (PSK/NYSE), has a 0.45% MER and yields 6.81%, paid monthly. Its holdings are similar to the iShares fund.