Dividend ETFs generate current income and they also offer tax advantages that may make them better than bonds or GICs.
When a fund invests for dividend income it usually sticks with highly conservative investments. These include preferred shares and common stocks of companies such as utilities that pay high dividends.
Straight perpetual preferred shares pay dividends that are fixed for the life of the security. They’re similar to bonds, but have no maturity date.
Today’s Canadian preferred share market, however, is dominated by rate-reset preferred shares. Rate-reset preferreds usually pay a fixed dividend until their reset date. On this date, if the shares are not redeemed by their issuing company, a new dividend rate is declared by management, and that dividend remains in force until the next call date. Periods between call dates usually last for five years.
The dividend is typically reset according to a specified spread based on the yield of the five-year Government of Canada (GOC) bond. If the yield on the GOC bond is 1.00 per cent at the reset date, and the specified spread is 200 basis points, then the rate will be reset at 3.00 per cent (1.00 per cent + 200 basis points).
Finally, common shares pay dividends that reflect the profitability of the company. These dividends often rise on a regular basis. For example, Fortis Inc. currently pays an annual dividend of $2.14. The company has increased its dividend each year for 48 years.
Gains and income or straight gains?
These differences in ways the dividend is paid can result in different performance records.
iShares S&P/TSX Canadian Dividend Aristocrats ETF (TSX—CDZ), for example, invests in established Canadian companies that have increased ordinary cash dividends every year for at least five consecutive years. Obviously, these shares have the potential to continue increasing their dividend year after year. If we see continuing economic growth, they’ll be more likely to do that. If we continue to see high inflation numbers, dividend increases will help protect investors.
Rising dividends and earnings are two key ingredients that propel share prices upward over time. They give the Aristocrats fund relatively strong appreciation potential over time. And this, plus the ability to increase dividends over time, makes the fund attractive for healthy total-return potential.
BMO Laddered Preferred Share ETF (TSX—ZPR), by contrast, invests in rate-reset preferred shares using a five-year laddered structure where annual buckets are equal weighted and individual securities within each bucket are market capitalization weighted. This ETF is designed for investors seeking higher income and not necessarily price appreciation. That’s because the price of the security will fluctuate with the rise and fall of interest rates.
But the ETF is expected to have lower interest-rate sensitivity than the full preferred share market. When interest rates rise, it has the capacity to pay higher dividends in response, and this will help buoy its share price. By contrast, straight perpetuals don’t increase their dividends, and this makes their prices vulnerable to rising rates. Straight perpetuals, however, typically perform better when rates decline. Rate-reset preferred share prices face downward pressure when rates fall, but the laddered structure of the BMO ETF helps to buffer that decline.
This is an edited version of an article that was originally published for subscribers in the January 21, 2022 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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