Tax-Efficient Source of Retirement Income

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Due to record low interest rates, bonds, guaranteed investment certificates, and mortgage funds are not providing many investors with a suitable rate of return to meet their income needs.

 The recent volatility of the stock market has forced many investors to the sidelines. For example, at the time of writing, a five-year GIC rate offered by a local financial institution is 3.25 per cent, while the two-year rate is two per cent. By comparison, the current government of Canada five-year bond has a yield to maturity of approximately 2.5 per cent and the two-year yield is 1.2 per cent.

In addition, interest income from these investments is taxed at the highest marginal rate, which means the money sitting in your pocket after the government has taken its cut has been reduced by 43 per cent for those in the highest marginal tax bracket. Factor in the needless but upcoming demise of high-yielding income trusts (thank you very much, Mr. Flaherty), and it means that many investors will be looking for a steady source of retirement income in the coming years.

Preferred shares have recently regained popularity due to their high dividend yields. The most recently issued shares yield in excess of five per cent and carry a dividend tax credit. So a properly diversified portfolio of preferred shares can provide investors with a high after-tax income in a relatively safe manner. However, there are certain risks that investors need to be aware of, so it is important to understand how and why corporations issue preferred shares.

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A corporation is a legal entity that is typically created for the purpose of carrying on a business. Its balance sheet is composed of assets (property, plant, equipment), liabilities (loans, mortgages, bonds issued to purchase assets), and shareowners’ equity (common shares, preferred shares, undistributed profit or retained earnings). When a company wants to grow, it can either borrow from lenders such as a bank or it can issue new shares of the corporation. If the business borrows, it has a legal responsibility to pay the money back plus interest. It will typically borrow when it feels that it can earn a better profit than the cost of the loan.

If a business can’t or doesn’t want to borrow money and still wants to grow, then it can issue new shares in exchange for new money. Common shareholders (owners of the corporation) own shares for two reasons. First, they hope to see the value of their shares rise over time. Second, they hope to receive a portion of the profits as dividends. Over time, as a business grows, the value of the shares and the dollar value of the dividends also grow, but they are not guaranteed. We just need to mention 2008 as a year of falling stock prices and dividend cuts from many corporations to justify our point. This is the main reason some people choose not to invest in common shares. They do not like the risk associated with falling stock prices and falling dividends. To overcome this failing, companies raise capital by issuing preferred shares in lieu of common shares.

Special Class of Stock

A preferred share is a special class of stock that pays the holders a preferential dividend and also provides them with superior protection above that of common shareholders should the company get into financial difficulty. The best way to understand preferred shares is to think of them as a hybrid security with features and benefits of both bonds and common stock. To give investors even greater confidence, major credit agencies assign a quality rating to each issue similar to the way they rate the quality of bonds issued by corporations. Like bonds, the better the credit rating, the lower the dividend yield.

Corporations usually issue preferred shares with a $25 par value and a stated dividend rate. The most common type is a straight preferred and is issued by most corporations. During the last decade, billions of dollars worth of straight preferred shares were issued and were very popular because the dividend yield compared favourably to both bond and common share dividend yields.

But they have two major drawbacks. First, since the dividend is fixed, corporations usually issue straight preferreds when interest rates are low. However, when interest rates rise, the market value of a straight preferred typically falls in an inverse relationship. If interest rates double, a straight preferred can fall by 50 per cent. Second, straight preferred shares do not have a fixed maturity and can remain outstanding for decades, well beyond the time horizon of most investors.

In the late 1970s and early 1980s, interest rates skyrocketed in response to rampant inflation. Straight preferred shares lost much of their trading value, leaving investors in a mini-panic. Corporations responded by issuing two new types of preferred shares. Retractable preferred shares give investors a maturity option at a fixed price for a stated period of time, usually seven to 10 years. In exchange for the retraction feature, these preferred shares usually pay a lower dividend than a straight preferred share. Since corporations don’t like refinancing preferred shares, most of these types have become a rare but attractive entity today.

For corporations that didn’t want the future liability of cash redemptions, adjustable-rate or fixed-floating rate preferreds became another method of raising capital. As the name suggests, dividends are not fixed but are adjustable according to a specific formula. The most recently issued preferreds pay a fixed rate for the first five years and then each successive five years are tied to Canada five-year bond yields plus a set rate premium. If interest rates skyrocket again, the dividend-reset option makes these shares attractive.

Holy Grail

During the 1980s, some mid-size and major corporations issued the holy grail of preferred shares. They were called cumulative (a term meaning any skipped dividends would be repaid in the future), retractable, fixed-floating rate preferred shares. These shares paid a high fixed current dividend, with an adjustment feature during times of rising interest rates and provided investors with a long-term retraction period. If a major corporation with a strong credit rating issues one of these again, mortgage your children, call your investment advisor, and load up.

Lastly, during much of the 1980s, many corporations chose to issue convertible preferred shares. These shares allow the holder to convert their preferred share holding into common shares under a defined formula. This feature is particularly attractive because it allows the owner to take advantage of future price increases in the common stock.

A diversified portfolio of preferred shares can provide investors with a steady stream of tax-efficient income, stability, and growth by creating a basket of retractable, convertible, and fixed-floating rate preferred shares. Alternatively, most mutual fund companies have preferred share dividend funds. For those reluctant to pay high management fees, Claymore offers the S&P/TSX CDN preferred share exchange-traded fund (ETF).