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Is it Time to Add some Income Stocks?

Derek Foster

If you have followed my investment approach at all, you know that I have focused on quality, dividend-paying stocks to achieve financial freedom. I have tried to buy what others were selling (with some successes and some failures) and overall this approach has turned out rather well. After the 2008-2009 stock market crash, I focused on adding quality US stocks as our Loonie was trading at parity or above, so US assets were cheap for us Canadians. More recently as our Loonie has fallen in value, I have been focusing more and more on adding some quality Canadian stocks to the mix and I highlighted my picks in my most recent video series update (http://stopworking.ca/about-the-video-series).

 

But one area where I have not really invested very much in the past is in fixed income...

The reasons for focusing on dividend-paying stocks is mostly because study after study has shown that stocks do better than fixed income (or bonds) over time. Having said that, there have been long stretches of time where bonds outperformed stocks by a wide margin. My reluctance toward investing in bonds was compounded by the fact that yields have fallen so much that there is tremendous risk in owning long-term bonds if interest rates start to rise again at some point. I realize that as interest rates fall, bonds increase in value (something that has been happening since the early 1980s), but when interest rates start to climb, this causes bond prices to fall. Right now, interest rates are at generational lows. I have no clue where interest rates are headed over time, but rising rates seem to be more likely than falling rates, and bonds seem too risky to me.

The other main issue that has always kept me away from fixed income investments is that they offer very little protection against inflation. If prices rise, the companies I own can increase their prices along with inflation, and thus increase their dividends in the process, whereas with fixed income, I am stuck collecting a fixed interest rate regardless of what happens to inflation. Investors who bought long-term bonds in the 1960s would have experienced huge real losses from their supposedly “safe” bonds. Since inflation has existed in every year since I was born (around the same time currencies were allowed to float freely unhitched to gold), I think that is a reasonable risk to be guarded about.

With all that, is there any fixed income that seems reasonable at this time? I know some investors look to corporate bonds at times, but that is not an area I follow very closely, and again, there is no protection against rising inflation or increasing interest rates. But, right now many preferred shares seem to be trading cheaply. In particular, rate-reset preferred shares seem to be trading at levels where they offer good value.

First let’s look at the difference between common shares (the type of shares I usually invest in) and preferred shares. Common shares are basically a partial ownership in a company. If the company does well over time and earnings rise, you might see your shares rise in value and/or ideally see the dividend that the shares pay rise over time. But preferred shares are different: they are more similar to bonds in that when you invest in them, you are offered a fixed dividend rate that should not change over time (the dividend rate usually doesn’t go up, but the dividend can be reduced or eliminated if the company runs into financial trouble). Usually the preferred shareholders must receive their dividends before any common shareholders receive their dividends—hence the term preferred.

So those are the basics behind how preferred shares work. Now we move onto the certain kind of preferred shares I mentioned earlier: rate-reset (or fixed-reset) preferred shares. What are these?

Initially, rate-reset preferred shares are very similar to normal preferred shares (usually called perpetual preferred shares) in that they offer a fixed dividend for a period of time (usually five years). At the five-year mark, the dividend rate is adjusted – usually based on the Government of Canada five-year bond rate plus some premium. So, for example, you might see that upon the reset date, the preferred share dividend rate will be set at the five-year bond rate plus 2%. In this instance, the yield would then be set at the 1% bond rate PLUS the 2% premium = 3%.

If inflation and/or interest rates were to begin to rise, the investor has some protection as the dividend gets reset at the bond rate plus a premium!

Okay, hope you follow this explanation so far...now for an interesting twist. The shares are issued at a certain pre-determined value called par value. So if the company issues shares at a $25 par value, and the dividend is $1 per year, then the yield would start off at 4%. But, once the shares have been issued, they will trade either above or below par value depending on what investors are willing to pay for the shares. This is the factor which has attracted my attention in this area...because right now many rate-reset preferred shares are trading substantially below their par values. Why?

During the last few years, interest rates have fallen quite a bit – which has really hurt rate-reset preferred shares. Falling interest rates hurt these investments because when they reset, the do so at lower interest rates – and hence they pay lower dividends. With the two additional Bank of Canada rate cuts in 2015, these investments have been really beaten up!

I could get into the nitty-gritty and offer specific examples of different preferred shares, but instead I will offer two preferred share ETFs to show how they have been hammered (remember – many investors buy these as “lower risk” investments).

The first ETF is called the Claymore S&P/TSX Canadian Preferred Share ETF and uses the ticker symbol CPD. This ETF owns all types of preferred shares, but the rate-reset component is the largest one. This ETF was first offered in early 2007 for $20/unit. As of this writing, you can buy them for around $12 each—a 40% drop from their initial price! This is not because the ETF is not well managed or anything like that; it’s simply because interest rates have kept falling and hurt the underlying assets. So the question investors have to ask is: “Do I think interest rates will keep falling? Will they become negative?”

If the answer is “NO”, then a preferred share ETF like this one might prove to be a good way to add some income to your portfolio. The other ETF that specializes in rate-reset preferred shares is BMO Laddered Preferred Share Index ETF (ticker symbol ZPR).

The final factor is that as I mentioned, many of these shares are currently trading substantially below par value. If they revert to par value (or if companies decide to redeem the shares which would be at par value), then investors would realize large capital gains to go along with their income.

I realize I have no clue where interest rates are going or what the future will bring, but I have done okay trying to buy what other investors hate and that describes rate-reset preferred shares as of this writing.

Derek Foster, The Idiot Millionaire and six-time National Bestselling Author, Ottawa, ON, www.stopworking.ca.