Dividend Income Portfolio Gets Revamped (Dividend Mistake #3?)

dividend

 

I’ve made a decision to revamp my dividend income portfolio to what I think is a tremendous buying opportunity in the world of Canadian Preferred Shares.  Time will tell if this becomes dividend mistake #3 (see mistake #1 and #2 here) and one would think that some of the yields on these preferreds are too good to be true. However, I welcome any comments and flaws in my thinking.

Those who follow my dividend income portfolio know its original intent was to provide additional income throughout the year with less focus on capital gains; as my Play Portfolio certainly provides enough excitement with respect to gains and losses.  The dividend income portfolio has definitely served its purpose – as of my last update, it has handily beat my benchmark dividend mutual funds in providing that extra cashflow I was after; while keeping pace with overall return.  Most also know that I am not really a big fan of investing in the Canadian market – primarily due to the sector breakdown of the TSX (with financials, energy, materials, and industrials accounting for over 70% of the market).  Outside of financials, my knowledge of the other major sector components is quite limited; so I was always hesitant to buy companies for the portfolio strictly for their dividend.

The Opportunity

If you own Canadian preferred shares, chances are you have experienced a horrendous return on investment this year (not including the 5% yield you probably would have received):

Canadian Preferred Shares (02-Jan-15 to 26-Aug-15)

Canadian Preferred Shares (02-Jan-15 to 26-Aug-15)

If the chart isn’t enough to show you how awful the preferred share market has treated investors, here’s the absolute values to sink your teeth into:

Index / ETF Symbol YTD Performance
iShares S&P TSX North American Preferred Stock Index XPF -10.9%
S&P TSX Preferred Share Index TXPR -20.0%
Claymore S&P/TSX Canadian Preferred Share CPD -19.7%
BMO TSX Laddered Preferred Share Index ZPR -25.1%

Possibly the first question is if they all follow the preferred share index, why do they have different YTD performance?

  • XPF, which we held in the original dividend portfolio is 50% weighted to the TSX Preferred Share Index, but 50% also comes from the iShares US Preferred Stock ETF (which YTD has returned -1.8%)
  • CPD does accurately track TXPR so its return is relatively on par with the index
  • ZPR is a laddered preferred which primarily consists of relatively newer class of preferred shares called rate reset which is where our opportunity lies

As discussed in my first dividend mistake buying a preferred shares, preferred shares trade like shares but act more like bonds.  Like bonds, most preferred shares experience the same inverse relationship as bonds have with interest rates – as rates rise, prices drop to reflect the discount required in order to match the yield to the higher rates.  This is true for preferred shares that have the property of being perpetual (i.e. have no maturity) or those that have maturity dates far in the future.  Prior to 2008, the majority of preferred shares issued in Canada were of this variety (with various other properties – cumulative, redeemable, etc.).

Post financial crisis, investors shied away from perpetual preferred shares – after all, interest rates were practically zero and had nowhere to go but up.  Buying new preferred shares would be committing suicide on the capital used to buy the shares.  And so, the Rate Reset Preferred Share was born, where it now accounts for nearly two-thirds of the Canadian preferred share market.  Unlike perpetuals, which guarantees the dividend forever (or until the shares are called), rate resets offers a way to protect against rising interest rates.  Approximately every 5 years, the yield would be reset to the Government of Canada 5-year bond plus a pre-determined rate spread.  Here’s a sample of some of the hundreds that exist today:

Preferred Share Issue Date Renew Date Spread (%)
Enbridge Inc Preferred Series 7 (ENB.PR.J) 9-Jul-12 1-Dec-18 2.65
Fairfax Financial Holdings Preferred Series E (FFH.PR.E) 1-Feb-10 31-Mar-20 2.16
Fairfax Financial Holdings Preferred Series K (FFH.PR.K) 31-Dec-12 31-Mar-17 3.51
Royal Bank Preferred Series BF (RY.PR.M) 31-Mar-15 24-Nov-20 2.62
Husky Energy Inc Preferred Series 3 (HSE.PR.C) 9-Dec-14 31-Dec-19 3.13

Now, preferred shares can go down in price on their own for any number of reasons.  If they’re perpetual, rising interest rates will cause prices to fall in order to bring the yield in line with market conditions.  The second biggest impact is if a company lowers its dividend or does not pay it out – you can almost think of it like when you miss a payment on your credit card.  That absolutely affects the credit rating of the issuing company, and investors’ faith that the company will continue to pay out the dividends they have promised.  Judging by the drop in the TSX preferred share index, you’d think all the companies listed are in dire straits but that’s simply not true.

What is actually happening is some of the preferred shares are experiencing rate resets that is reducing the yield from when the share was first issued.  Lowered dividend means lower prices – example: the Series E preferred shares from Fairfax Financial Holdings.  Fairfax is sometimes referred to as Berkshire Hathaway (BRK.B) North – basically operating as a holding company engaged in insurance, and investment management.  Currently with a market cap of over $13B, and TTM earnings of $38/share, it’s pretty safe to say that the company is not in any financial distress.. So, what’s happened to the Series E preferreds?

FFH.PR.E Aug 2014 - Aug 2015

FFH.PR.E Aug 2014 – Aug 2015

When the preferred shares were first issued in 2010, the initial yield was set at 4.75% based on the face value of $25 – good for quarterly dividends of $0.296875.    The first option to call, or reset the rate would occur on March 31, 2015.  Well, instead of calling (buying back shares at $25), Fairfax decided to reset the rate – lowering the dividend to 2.91% or $0.1819.  What would make a company reset vs. call?  Well, the most likely scenario for calling would be if the current market rates were lower than the reset rate – calling the Series E and issuing a new Series at a lower rate would reduce borrowing and interest costs.  Unfortunately, resetting the rate meant that investors who were part of the initial issuance @ $25 who were hoping for higher interest rates and yields, were now holding an investment that returned no more than a short-term bond; but also has dropped 45% in value.   Ouch!

Lower yields from rate resets can absolutely be attributed to this year’s two rate cuts by the Bank of Canada.  Now that the first few rate resets are being reset with these new rates, many preferred shares are being sold off in anticipation that they will also be reset at lower rates once renewal time comes.  Preferred shares are also primarily owned by individual investors (not institutions, or pension or hedge funds, or day traders) so large movements in a downward direction for what should  have been considered “safe” tends to make these investors emotional and fearful.   Adding to this pressure, is the liquidity of the preferred share market – shares trade anywhere from a few thousand to tens of thousand a day.  A mass exodus out of something so thinly traded is bound to cause greater dips in price.

 

So, how do we benefit?

I feel that the drop in preferred share pricing, while valid for some (especially those that reset at extremely low yields), have left some preferred shares at very reasonable discount prices that a) should benefit when rates rise and the rate is reset again, or b) provide potential for decent capital gains while providing respectable yields to wait.  Currently, the Government of Canada 5-Year bond yield is sitting at a decade low:

GoC 5YR Bond Yield 2005-2015

GoC 5YR Bond Yield 2005-2015

 

Some are predicting that rates can still go lower, but with the US on the verge of reversing course and starting to raise rates after nearly a decade of cheap money, I’d argue, that Canada must eventually follow, as it normally does 95% of the time.  There’s only so long that Canada deviates from the US before the Canadian dollar drops so much, that goods become more expensive, and the BoC is forced to raise rates.

Example:

Fairfax Financial Preferred Series K (FFH.PR.K)
Price: $17.06 (price purchased on 25-Aug-15 while researching this article)
Dividend: $0.3125/quarter or $1.25/year
Yield: 7.3%
Reset Date: 31-Mar-17
Spread: 3.51%

Here’s a case where low trading volume and the overall negative view of the preferred share market can lead to a great opportunity to buy.  The Series K currently yields 7.3% (which actually gets sweetened with the dividend tax credit)  and will reset just under two years from now.  Even if the Bank of Canada continues to lower rates all the way to 0%, the rate reset would yield 3.51% – good enough for $0.88 / year.  Applying what would be a reasonable 5% yield required for any newly issued preferred shares, that values the shares at $17.60 –  even higher than the current price today!  Run through a few scenarios, and you’ll see that if you can deal with the current price volatility, these shares provide a pretty good argument for owning.  Let’s also not forget that we also continue to collect the 7.3% while we wait for renewal time.

BoC Rate Rate Reset Yield Dividend / Year Yield at Cost Potential Share Price Potential Capital Gain
0% 3.51% $0.88 5.1% $17.55 2.9%
0.5% 4.01% $1.00 5.9% $20.05 17.5%
1.00% 4.51% $1.13 6.6% $22.55 32.2%
1.25% 4.76% $1.19 7.0% $23.80 39.5%
1.50% 5.01% $1.25 7.3% $25.05 46.8%
1.75% 5.26% $1.32 7.7% $26.30 54.2%
2.00% 5.51% $1.38 8.1% $27.55 61.5%
2.50% 6.01% $1.50 8.8% $30.05 76.1%

What also makes this specific preferred share interesting is the wide-spread.  The larger the spread, the greater potential that the company might be able to issue new shares/debt at lower rates; and actually call the shares for $25, triggering a nice 47% capital gain in 2 years.  Of course, there’s no guarantee that they will be able to – but if not, we’re still fine holding onto shares and getting the new yield (which should also result in higher prices anyways).

Now, obviously, this is a pretty simplistic view.  Some outside risks that can be investigated (though I suspect the likelihood is minimal):

  • a reasonable yield in 2017 becomes 6, 7% or higher (although this might only be the case should Canada experience its own financial crisis similar to 2008)
  • rates go into negative territory
  • Fairfax, and other preferred share issuers, credit risk increases

So, we’re revamping our dividend income portfolio based on what we feel are undervalued preferred shares that will be reset in the next 3-5 years at what we predict will be higher rates and either provide even better yields than they do today, or provide some potential capital gains.

Food for thought for the truly aggressive

I actually had a thought to initially fund the portfolio this way, but decided against it due to timing of potentially moving to a new home, and what would be required to sell the portfolio at a gain or loss.  For those who have a lot of home equity built up, the following might be a way to be super aggressive as a home, home equity line of credits (HELOC) and preferred shares are all interest rate sensitive:

  • use a Home Equity Line of Credit (HELOC) to fund the creation of the rate reset preferred share portfolio
    • current preferred share yields currently surpass HELOC rates
    • dividends provide greater benefit from the dividend tax credit
    • interest from the HELOC can be written off
    • current and future dividends should be able to pay off any interest
  • if rates go lower
    • the drop in the preferred shares is offset by the general price appreciation of the house
    • yield still remains higher than the HELOC rate (at least until rate reset)
  • if rates go higher
    • rise in price of preferred shares partially offsets drop in housing
    • yield should still be able to cover HELOC rate (if preferred with large enough spreads are purchased)

 

So, to wrap up, we’re revamping our dividend income portfolio based on what we feel are undervalued preferred shares.  Prediction is shares that will reset in the next 3-5 years will be higher rates and either provide even better yields and should lead to some decent capital gains.

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5 thoughts on “Dividend Income Portfolio Gets Revamped (Dividend Mistake #3?)

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