A preferred security is a great addition to your RRSP, but we know of only one Canadian issue.
We include one preferred security selection in our Recommended Preferred Shares list. It is, of course, recommended as a buy.
The selection is Top 10 Split Trust (TSX—TXT.PR.A). It’s part of a split share investment trust designed to provide unit-holders with exposure to the six largest Canadian banks and four largest Canadian life insurance companies.
While owners of the capital units of the trust seek capital appreciation and some income, owners of the preferred securities seek purely income. The objective of the preferred securities is to provide fixed quarterly cash interest payments equal to 6.25 per cent per year on the $12.50 principal amount of the security. The principal amount will be repaid to unit-holders on the securities’ maturity date, which is currently March 31, 2021.
Issues are scarce
That brings us to a problem with this security type: it’s the only one left in Canada we know of. Mind you, there were never that many issued in the first place. And of those, many ended up getting redeemed, to the point where today, Top 10 Split is the only issue we know about.
At one time, virtually all preferred security issues were issued on behalf of a single operating corporation, such as Shaw Communications or TC Energy. Once those issues were all redeemed, subsequent preferred security issues were from structured corporations such as Top 10 Split Trust.
The reason we recommend this preferred security is that it’s a good security type for your RRSP and other registered accounts. For example, Top 10 Split Trust yields 5.31 per cent to mandatory call in 2021, and 6.19 per cent on a current yield basis. Compare that to the 1.14 per cent you’re likely to get on a Canada bond maturing at about the same time.
Higher yields come with higher risk
Higher yields do not come without higher risk, of course. One of those risks is that the issuer redeems the preferred security prior to its mandatory redemption date, forcing you to find a new investment to replace it for the remaining part of your time horizon. This is most likely to happen if interest rates decline sufficiently to warrant the company calling the issue in, which means that you could end up reinvesting for the balance of the term at lower rates.
Plus, because preferred securities have a structured corporation as their underlying security, its income stream is based on the investments it holds in other securities. For example, Top 10 Split Trust is based on an underlying portfolio of the common stocks of Canada’s big banks and insurance companies. Its two largest holdings are Toronto-Dominion Bank (TSX—TD) and Royal Bank of Canada (TSX—RY). If the dividend income from this portfolio declines—as inconceivable as that might seem—payouts on the Top 10 Split Trust preferred securities would be compromised.
With those risks acknowledged, we especially recommend Top 10 Split Trust preferred securities for your registered account.
Preferred securities: debt or equity?
Are preferred securities part of a company’s debt load, or are they part of its equity base? The answer is, “both, really”.
Preferred securities are a hybrid security type that is listed on a company’s balance sheet below all its debt, and above any preferred issues outstanding.
What makes them like debt?
■ Preferred securities pay a regular, fixed income.
■ That income is taxed as ordinary income.
■ Preferred securities have a maturity date, or something equivalent such as a mandatory redemption date, that is often many years in the future.
■ They trade on a yield basis: when rates go up, prices fall and vice versa.
What makes them like equity?
■ Preferred securities usually pay income on quarterly basis, like dividends, rather than semi-annually like bonds.
■ Preferred securities are typically listed on a stock exchange, and trade like stocks on an auction basis, rather than like bonds, which trade on a dealer basis.
■ The issuer can classify preferred security capital as equity rather than debt for accounting purposes.
This is an edited version of an article that was originally published for subscribers in the February 14, 2020, 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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