Friday, 21 September 2012

Dividend Income from High Quality Preferreds: Split Shares, Companies and ETFs Compared

Preferred shares have several attractive features for the investor seeking income:
  • Tax-advantaged dividend income, which can be worth up to 20% more after tax, depending on province and income level (see the Ernst & Young 2012 Personal Tax Calculator) e.g. 3% of dividend income produces as much net of tax as 3.6% of interest in a taxable account.
  • Constant, reliable, regular income flow, like interest (with a caveat when it comes to ETFs, as discuss below)
  • Greater certainty of payment than dividends on common shares since preferreds almost always take payment precedence over common shares
A few years ago, we explored split share preferred shares, outlining other important risk and reward features. We also found some attractive yields amongst them. Today we'll have another look and compare the other options - individual company preferred share issues and ETFs holding a basket of company preferreds. We'll restrict ourselves to safer investment grade shares i.e. those rated as Pfd-2 or Pfd-1 by the credit rating agency DBRS.

The Investment Grade Split Share Preferreds
These come in two varieties - securities of a single company, or one that holds multiple companies. From our detailed comparison table below, we find some good and some not-so-good-looking investment possibilities.

Beware the return illusion of current yield
Most of the data is just straight drudge work copying from the provider websites but one key element, the yield to maturity, which is how much the investment promises to deliver if held to maturity, was calculated from Shakespeare's free downloadable spreadsheet. Most importantly, the spreadsheet properly takes into account, as well as the regular dividend payment, any change in principal value between purchase and eventual maturity or redemption of the preferred share. This factor often destroys what looks to be a good return at first glance, seen in the table as the current yield (highlighted in our caution orange colour), which is simply the dividend payment as a percentage of purchase price.

Since the market price in almost every case exceeds the eventual maturity price the investor will get back, the current yield is very deceiving. It is higher in almost every case than the yield to maturity. The only exceptions are BAM Split Corp. 4.35% Class AA Series III (BNA.PR.C) and BAM Split Corp. 4.35% Class AA Series V (BNA.PR.E), where the shares trade at a discount so there will be a capital gain.

Beware the danger of early redemption
The worst situation is First Asset CanBanc Split Corp. (CBU.PR.A). The current yield looks nice at 5.00% but the real return the investor will get paying the $13.00 market price to receive only $10.00 at maturity on 15 January 2016 is a negative 1.8%. In fact, the outcome will likely be even worse. Since the fine print of the corporation's rules allow capital shareholders to submit shares for reimbursement at Net Asset Value once a year in January, and since the market price of the capital shares is now 20% (or $6.50) less than NAV, it is quite likely speculators will see a pretty good bet and submit capital shares for retraction this coming January, which will cause the company to pay back an equal number of preferred shares. Buying for $13 now and getting $10 back in January from the corporation is not the way to make money!

A number of other shares are exposed to this danger, as highlighted in red in the column titled Yield to Possible Early Redemption. The more the capital share is trading at a discount to Net Asset Value (NAV) and the greater the premium of the preferred over its redemption price, the greater the danger. In addition to CBU.PR.A, Utility Split Trust (UST.PR.B) looks quite bad in this regard.

A couple of attractive preferreds
Both our two discount preferreds - BNA.PR.C and BNA.PR.E look quite good as investments. Both offer very solid yield at around 5% and it is highly unlikely either will be redeemed early. The conditions for these issues state that if the corporation decides to redeem early it will have to pay $26.00 now for each share of the preferreds, sliding downwards year by year to the eventual maturity redemption price of $25.00 (see details at PrefInfo). Unless something really goes wrong at Brookfield Asset Management the company that underpins the whole corporation (and DBRS thinks there is plenty of protection and sfaety with its Pfd-2Low rating), the preferred shareholders should receive their steady returns till 2019 and 2017 respectively.

The Alternatives - Company Preferreds and Preferred Share ETFs
The bottom of our table shows a sample of the many company-issued preferred shares. The Brookfield Asset Mgmt Inc Cl A Pr Ser 12 (BAM.PR.J) comes directly from the same company on which BNA.PR.C and .E are based. BAM.PR.J's yield to maturity is almost 1% lower, which is quite a lot. Either investors see extra risk in the split share structure and thus demand a higher yield from the BNA shares, despite what DBRS thinks in rating the two securities with the same Pfd-2Low, or the current yield illusion is at work.

On the other hand, two other company preferreds from Great West Life and Power Financial, both rated more secure by DBRS at Pfd-1Low, have yields a bit lower than the BNAs'.

The three ETFs holding baskets of Canadian preferred shares have yields close to the our best split share picks and generally appreciably higher than those of the other splits. Adding in the ETFs' better diversification from much broader holdings, should ETFs be the best choice for the average investor? A couple of extra factors might affect that conclusion. First, two of the ETFs, iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) and Horizons Preferred Share ETF (HPR) contain a fair chunk (18-25%) of lower grade Pfd-3 preferreds (though none at the junk end of the spectrum). That boosts dividends but increases risk. Second, though the yield to maturity is as shown, the ETFs never mature and the investor will have to sell at some point to get back the capital. As interest rates and economic conditions vary the price of the ETF will too, unlike the fixed maturity / redemption value of all split, and some company, preferreds. The yield to maturity will vary with changes in duration of the fund as holdings get bought and sold or mature. Third, the yield to maturity will be about 0.50% less than that shown in our table due to the ETFs' MER. Finally, the cash distributions of the ETFs vary too, as can be seen by checking the ETF provider Distributions pages for Horizons, Powershares, and iShares.

Disclosure: This blog writer owns GWO.PR.H and BNA.PR.C shares.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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