How to buy the income from Canada’s big six banks

The Money Reporter is “for investors whose interest is more interest”. The pursuit of higher income in a low interest rate environment brings us to a preferred split stock that owns Canada’s big six banks and pays you more than the yield of its underlying portfolio of those bank stocks. How can that be?

We’ve added Allbanc Split Corp. II Class B Preferred Shares Series 2 (TSX—ALB.PR.C) to the Money Reporter’s list of recommended preferred shares.

We recommend Allbanc Split Corp., because we have a positive long-term outlook on the big six Canadian banks it covers, and because these shares have some interesting attributes if you want to enhance your income.

Split shares in general start out as a corporation that sells both preferred shares and capital shares to the public. The proceeds are then reinvested in one or more publicly-traded dividend-paying common shares. In Allbanc Split’s case, it’s the Big Six Banks.

Holders of the preferred shares, in turn, receive a fixed dividend based on what the underlying common shares pay in dividends, plus par value at maturity. Holders of the capital shares receive any dividends paid by the underlying common shares over and above what the preferred shareholders are entitled to, plus any excess over the par value of the common shares at maturity.

Hence the split. Basically, the dividends from the underlying portfolio go to the preferred shareholders, and any gains in the portfolio value go to the capital shareholders.

If that seems confusing, a real-life example using the Allbanc split issue might help. First, on Feb. 26, 2016, Allbanc sold $17.6 million worth of Class B Series 2 preferred split shares at $25.67 each. The purpose of the sale was to fund retractions of capital shares and all of the Class B Series 1 preferred shares. On the close of this offering, two of the capital shares and one of the preferred shares were considered to be a “unit”.

A portfolio of the Big 6 Canadian Bank Stocks

Currently, all the units, which have a net asset value of $76.23 each, are invested, in different weights, in common shares of Canada’s big six banks: Bank of Montreal, Bank of Nova Scotia (or Scotiabank), Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank, all of them solid blue chip stocks, of course. Meanwhile, the Allbanc preferred split shareholders are entitled to a fixed quarterly dividend of $0.3048 a share, which works out to a yield of 4.75 per cent on the issue price of $25.67.

That’s considerably higher than the 3.66-per-cent yield of the underlying portfolio of bank shares. How can that be? It’s attributable to the fact that the preferred split share investor receives dividends on roughly $30 worth of shares for every $10 of their own money invested. In other words, the preferred split holder gets dividends based on both the money they put up and the money the capital shareholders put up.

There’s an added bonus in the Allbanc case. Based on the performance of previous years, the portfolio of bank stocks should typically pay a dividend that exceeds the 4.75 per cent rate, after corporate expenses. That means the Allbanc dividend should be more than covered and, therefore, will likely be safe, subject to one or more of the banks drastically cutting its own dividend rate.

At maturity, the preferred split shareholders will receive back their par value, which in the Allbanc case is $25.67 a share, on Feb. 28, 2021. Of course, that assumes the portfolio of bank shares doesn’t drop drastically in value by that time.

That’s why income investors like preferreds split shares so much. They get a higher dividend than the underlying portfolio, and the dividends are eligible for the tax credit.

We recommend Allbanc Split Corp. II preferred shares as a buy for safety and income.

Downside protection explained

There are a couple of measures you can use to determine the quality of a split share. One of these is dividend coverage, which should generally be 1.0 times or higher. Dividend coverage is similar to interest coverage, in that the cash flow available for the payment should be at least equal to the payment, if not more. In the case of Allbanc, the underlying portfolio has generated more cash in most years after deducting operating expenses than the 4.75-per-cent payout on the preferreds. In other words, coverage has exceeded 1.0 times.

Another measure is downside protection, and again, the higher the figure the better. If for example, a split share issue has downside protection of 67.6 per cent, this means that the portfolio of underlying shares could drop as much as 67.6 per cent and there would still be enough money to pay the preferred split shareholders the par value at maturity.

For example, the net asset value (NAV) of each of Allbanc’s units is $79.23. Each unit is composed of two capital shares and one preferred split share. The NAV of a capital share is currently $26.78, or $53.56 for two shares. Subtract the latter amount, which is equal to 67.6 per cent of $79.23, from $79.23 and you get $25.67, exactly enough to pay the preferreds their par value.

 

This is an edited version of an article that was originally published for subscribers in the March 17, 2017, 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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