yield | Financial Crooks

Our investments are mostly a mixture of fixed income and equities. Our fixed income is invested in GICs, HISAs and bond funds. Our equity holdings include “buy the entire market” ETFs and dividend-paying ultra-conservative stocks. Recently, I have been trying to decide what else to invest in to provide a steady income stream without being overly aggressive on yield or excessive on risk. An opportunity came up to buy some preferred shares in a major Canadian utility and I did so. Now I’m stepping back a few paces and trying to evaluate the merits of that investment versus how risky it is and decide whether to continue to hold my preferred shares or sell them.

Leaving the Nest: The First Flutters Away from GICs

For most of my “investing” life, guaranteed investment certificates have paid a reasonable rate of return. Being ultra-conservative and ultra-risk averse, I happily sacrificed growth for security. I’ll never be a multi-millionaire with this strategy but then I don’t need millions to live the lifestyle I want.

Only once we had enough saved in GICs to ensure a modest retirement income, did we start deliberately investing in the murky world of equities.

So I am still learning about what types of investments we can make and how risky they are.

My First Purchase of Preferred Shares

A few months ago, I purchased my first preferred shares. They were issued by a company with an excellent credit rating and a long history of paying its dividends in full and on time. The yield at the time I bought them was a bit over 5%.

Since then, I’ve brooded about whether they are a good choice for me. Here are some of the pros and cons of investing in these particular preferred shares:

Pros for My Preferred Shares

The yield on our investment is over 5% a year.

I bought them at a price below the “call” price. That means the issuer cannot buy them back from me for less than I paid for them. I can only experience a capital gain if the issuer “calls” the shares.

I have a chance of making a small capital gain if interest rates stay low and I sell the preferreds. In fact, these shares have already seen a capital gain of 1-2%. It’s even possible for the price to rise above the call price of $25 although it’s not likely to rise very much higher than that.

The utility that issued the preferred shares has been around for a very long time and is very stable. The risk of the company being unable to pay their dividends on time is very low. The risk of the company going bankrupt is extremely low.

The dividends for these preferred shares must be paid before the dividends for common share holders can be paid.

The payments are cumulative. That means if the issuer fails to pay a dividend one quarter it must eventually make up that missing payment.

The dividends issued by these preferred shares are eligible Canadian dividends from an eligible Canadian corporation. That means that the income is taxed at a lower rate than, say, interest paid on a GIC or a bond if I hold these shares in a taxable account (which I do.) So the amount of money I get to keep from these 5%-yield preferred shares is higher than the amount I get to keep from a 5%-yield GIC. It isn’t any higher, though, than the amount I would get to keep from dividend payments from common shares of say, BCE. (According to Tom Slee a preferred like this yielding 5.1% is about equivalent to a bond yielding about 6.75% in a taxable non-registered account.)

Interesting Fact about Preferred Shares

Historically, according to BMO preferred shares do not show a strong correlation to common shares or to fixed income investments. In other words, if common share prices drop or rise significantly, preferred share prices don’t usually move significantly in the same way each time, nor do they react predictably to bond prices and yields.

This historical indifference, though, could change.

Cons for My Preferred Shares

The maximum achievable capital gain is very small because the issue can be “called” by the issuer at various prices. By 2016, the issuer can call it for $25 per share. That means buyers are very unlikely to pay more than $25 a share as the date for that call price approaches.

I don’t have an option to convert the preferred shares into common stock in the utility.

The dividend will never increase.

Inflation may rise so the value of my dividend may gradually diminish.

Even if interest rates increase and yields on other investments increase, the dividend on this investment will not increase.

If interest rates rise and the yields paid on other investments rise, I won’t be able to sell my preferred shares to recover my initial capital investment.

For example, say I bought my preferred shares at $24 and they pay $1.20 a year each. If new preferred shares are issued at $24 paying $1.80, then no one will want my preferred shares. Well, they might if I drop my price from $24 to, say, $16. Then for each $24 a person spends they get $1.80 a year, whether it’s from 1 of the new shares or 1.5 of my shares.

So I would experience a capital loss of $8 per share if I had to sell. That would wipe out any dividends earned for nearly 7 years! (even longer if you include a factor for inflation.)

Why Some Common Shares are Preferred over some Preferred Shares

Many of the above factors are why BCE common shares are so popular right now. They are paying about a 5% yield on shares that have the possibility of almost unlimited capital gains, which cannot be “called” at a fixed price on a schedule by the issuer, and for which the annual dividend can and likely will be raised (based on BCE’s dividend history.) Of course, the price of BCE common shares depends on the performance of Bell itself. The company could tangle itself up like Nortel did and its common share value could plummet. It’s not as safe or regulated as the utility whose preferred shares I bought.

Some Preferred Shares May Still be Preferable to an Annuity

These type of preferred shares might also be a better investment than some annuities. With an annuity, the income is also fixed at the time of purchase and often is not indexed to inflation. (It may be higher than 5% though.)

When the last survivor dies, generally the principal of the annuity dies with him or her. There is usually no principal returned to the estate.

If someone dies who holds preferred shares, however, the shares might still have a capital value. It might only be 1/4 or 1/2 of what was paid for them, but it’s still a cash value.

Note that much of the income from an annuity is often insured so that it will continue even if the issuer goes bankrupt. None of the income from the preferred shares is insured and if the issuer goes bankrupt then the income from the preferred shares will be lost. They are not interchangeable investments.

What Will I Do with My Preferred Shares?

My shares have paid me a few dividends and right now stand to win a small capital gain if I sell them.

If interest rates rise and companies start offering investments that pay a higher return than my preferred shares pay, then I may face a substantial capital loss.

A 5% return is not all that high when inflation is running about 1-2% a year.

I think I will probably sell my preferred shares sooner rather than later.

UPDATE: Sold! And yes, I feel good about the decision. I made a small capital gain and received some great dividends. Now I’ll look for a home for the capital that feels more comfortable to my risk-averse soul.

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Do you invest in preferred shares? Do you only buy retractable or rate reset shares instead of perpetuals? What factors sway your investing decisions? Please share your views with a comment.

I hope to fund part of our retirement costs with dividend income. That’s led me to invest in a few dividend paying ultra-low risk stocks over the past few years. When I bought each position, I thought about the dividend yield it was offering and whether it seemed reasonable compared to the interest yields available from fixed income investments. One thing that became obvious was that dividend yields tend to be fairly low at the time of purchase considering the amount of risk you’re taking by investing in the stock market. I do own one blue chip stock, though, that is currently paying me a dividend only yield of 17%.

Percentages Can Be Deceptive

One thing I’d like to warn you is that you can’t live off percentages.

You may have a stock that is paying you a 7% annual dividend. That sounds great. Your bank account is probably only paying you 1.35%. And your one-year GIC is probably only paying 1.65%. At 7% you must be cruising, right?

Well it depends on how much money you have invested at that 7% yield. If you only have $1000 of that stock, your actual take home income is $70 a year before taxes. It’ll pay the high speed internet bill for one month, but it won’t pay the winter’s natural gas bill.

What Is the Real Percentage Yield?

I started this by mentioning I have a stock that’s paying 17%.

It would be more appropriate to say it’s paying $336.53 a year.

The percentage yield is very deceptive.
The initial investment in the stock was $1946.25.
In theory, that could mean the dividend yield for this stock is 17.2912%.

But is that realistic?

Present Day Dollars are Not the Same as Past Dollars or Future Dollars

To calculate a more realistic yield, I think I would have to change the value of the initial investment into “today’s” dollars.

For example, if I spent $1000 on January 1, 2012, that would be comparable to having spent $1012.38 on January 1, 2013. I could have purchased more for the same money a year ago because inflation was less. Or I could have purchased the same amount a year ago for less money because inflation was less. (I used the Bank of Canada Inflation Calculator for this example.)

So what would the cost, $1946.25 be in December 2013 if I had to buy those shares then?

According to the Bank of Canada calculator, it would have cost me $2880.64 to buy the same shares in 2013 that cost me $1946.25 all those years ago.

Out of curiosity, I also poked around the internet and found a couple of US inflation calculators.

According to data from Oregon State University and a calculator at http://www.davemanuel.com/inflation-calculator.php, if I was talking USD, the $1946.25 would be $3338.34 in 2013 dollars.

According to the calculator at http://stats.areppim.com/calc/calc_usdlrxdeflxcpi.php, it would be $2997.53 or using CPI data $3 325.39.

Why is there a difference? Because it depends on what values you use for the inflator/deflator.

The actual value doesn’t worry me too much. What I’m trying to point out is that the dividend yield would be more realistic if I divided the payment of $336.53 by $3 338.34, not $1946.25.

So what is that reduced yield? 10.08%

Why It’s Worth Buying Dividend Paying Stocks That Routinely Increase Their Dividend

The yield of 10.08% on this stock is still pretty good.

If I bought more shares in the exact same company today, I’d only get a 2.22% dividend yield.

At the time the first dividend was paid a few years after the shares were purchased, the yield was 0.15%.

You can see that the dividend has increased significantly over the years. In fact, unless I’m screwing up my math again, it has increased faster than the rate of inflation.

If a stock increases its dividend at a rate greater than inflation, and if I buy that stock when the dividend yield seems reasonable, then I consider the purchase to be similar to buying an annuity. Provided I keep that stock (and the company continues to prosper) I can receive a steady income stream that keeps up with or exceeds inflation.

Obviously buying stocks is much more risky than buying an annuity:

any company can fail
a dividend can be reduced or eliminated without warning
a company can decide to stop increasing a dividend without warning
if you sell shares of a company you can lose capital

However, unlike an annuity, my money is not actually locked in. If I pay attention to the business fundamentals for the company, and if I’m lucky, I can sell a stock that begins to under perform and buy something else. I may lose capital by doing this!

On the upside, though, I may also find my stock appreciates in value. If so, I can sell part of my stock and use the capital gains to invest elsewhere or to spend. (Of course if I sell the stock I will stop receiving the dividend: it’s that Goose that lays the Golden Eggs thing all over again.)

Is Buying Dividend Paying Stocks a Good Retirement Plan?

I honestly don’t know. It’s part of my strategy but certainly not all of it. I have

a big chunk of money in fixed income (and because I am extremely risk averse it is a very big chunk);
another big chunk of money in “buy the entire stock market” ultra-low fee ETFs
a small amount of money in individual dividend-paying ultra-low-risk stocks

At this point, I would say only my future “vacation for a week somewhere further south than Timmins” retirement money is invested in individual stocks. I can forgo the annual vacation in retirement if I have to. I can’t forgo eating.