Preferred split shares explained

Preferred split shares are not your run-of-the-mill preferred shares.  Split preferreds serve a specific need of some income investors. But you don’t get the extra income without shouldering some extra risk. So, as always, investigate before you invest.

Preferred_Split_SharesPreferred split shares do fit a need for investors such as us—the income investor. So rather than shy away from them entirely, let’s take a look at what you should keep an eye out for in choosing a preferred split share.

Let’s start with the basics of what a preferred split is, by talking first about common shares rather than preferreds. Right now if you bought all the stocks on our list of recommended shares, you’d get an average dividend yield of 3.42 per cent.

Now suppose you and a friend both own those stocks, and your friend offers you a deal. He’s willing to give you all his dividend income going forward, in exchange for you giving him all your capital gains over the same period.

You get twice the yield

Do you go for the deal? If you do, you’ll get a yield of 6.84 per cent on the money you’ve invested: 3.42 per cent from his portfolio, and another 3.42 per cent from your own. Add in the dividend tax credit, and your equivalent pre-tax yield is well above seven per cent, which is much more than a five-year GIC pays right now. More, too, than the bond market offers.

If you go for it, you value income more than capital gains. Your friend values growth more than current income. For example, if one of his shares goes up by $10, he’ll actually profit by $20, because you have an equal number of shares that will also be up by $10.

To satisfy both types of investors, financial institutions have created split shares.

Basically, the issuing financial institution buys a block of common shares in one or more companies, and puts them into a corporation, whose only asset is those shares. These shares are called the ‘portfolio shares’ of the split corp. Then the financial institution sells two kinds of shares in the split corp to the investing public.

Buyers of ‘capital shares’ of the split corp get all of the capital gains made by the portfolio shares, but none of the dividends. Buyers of the ‘preferred shares’ get all of the dividends, and none of the gains.

At some predetermined date in the future, the split corporation is then wound up. At that time, the preferred shareholders get back a stated par value, or less if the portfolio shares have fallen in value. The capital shareholders get back anything in excess of that same par value, which could be anything from zero (if the shares have fallen in value) to infinity (if the shares have risen in value to infinity).

Things to watch out for

These are the basics of how split preferreds work. Here are some additional things to watch out for.

For one, the preferred split shares should ideally pay about double what the underlying shares yield. Take, for example, Partners Value Split (TSX—PVS.PR.D), which holds shares of Brookfield Asset Management Inc. (TSX—BAM.A). The preferred splits yield 4.37 per cent. Brookfield itself yields 1.35 per cent.

Allbanc Split II (TSX—ALB.PR.C) invests in shares of Canada’s big banks in different proportions. Its yield is 4.58 per cent. But the underlying portfolio itself yields 3.82 per cent. That’s not such a great deal. On the other hand, Allbanc’s diversified portfolio of Canada’s top banks is much more conservative than Partners’ investment in one security. More risk averse investors might, therefore, prefer to invest in Allbanc, which has a higher yield and yield-to-call than Partners.

Focus on yield-to-call

Also look at the preferred split’s yield-to-call. It’s important because it’s a more accurate reflection than the current yield of what you will get on the shares if you hold until the redemption date.

And that brings up another risk of preferred splits. Split share companies have the option of redeeming a percentage of your preferred split shares every year on their annual retraction date. (This date is usually on the anniversary of the final redemption date).

Plus, as we noted above, you could end up with less than par value at the end.

Split preferreds serve a specific need of some income investors.  But you don’t get the extra income without shouldering some extra risk.

This is an edited version of an article that was originally published for subscribers in the August 31, 2018, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

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