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Canadian investors have toughened up, and more lessons my clients have taught me during this crisis

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Over the past few weeks I have been having some interesting conversations with clients.

While the conversations usually include discussions about investments, we often spend more time discussing family, health, today’s challenges and tomorrow’s hopes. If it ever wasn’t clear before, it is very clear now that our investments are here to serve a broader purpose — which is to allow us to live as full a life as we can.

As I talk to more clients I will no doubt be learning more from each of them.

Here are my big five takeaways to date:

From a Canadian perspective — COVID-19 truly is unique

Turbulent global markets due to covid-19 In a recent chat with a 99-year-old client who was born in Canada, I asked him if he had ever seen anything like what we are experiencing today. I was surprised when he said “Never in my life.” He did say that things were clearly difficult during the Second World War, but we were never so totally shut down like we are today.

His comment was definitely a jolt to me. This is historic. It is obviously not business as usual. We need to treat it very seriously from a health and investment perspective.

From a non-Canadian perspective — COVID-19 brings back other memories

Another client in his 50s related a story from his childhood, growing up in a war-torn nation. He remembered staying at home, being warned about going outside. He said that he could now better relate to his father’s worries about supporting the family when almost everything was under siege and there was no work to be had.

COVID-19 is clearly bringing memories of war and sacrifice. It is a reminder that life can be hard, unfair and unyielding. The fact that this brings comparisons to terrible times of war is a reminder of how significantly strange times have become.

The Financial Crisis of 2008/2009 has created a tougher investor

During the Financial Crisis, there was fear that big banks would collapse. There was a worry that stocks would drop 90 per cent before it was over. Few if any investors had lived through such a broad and deep investment crash. At the time, there were a meaningful number of clients who had to be convinced not to sell out their portfolios with large losses.

Yet, they ultimately saw how markets eventually recovered and thrived.

Today, most investors lived through 2008 and 2009. Their reactions to COVID-19 related declines have been much calmer. This isn’t to say that everyone feels that way, but a much higher percentage recognize that this pandemic will end, whether in a couple of months or a year. Likely, before it ends, stock markets will make a sizeable comeback.

There remains an overconfidence that people can time the bottom of the market

Some clients have expressed frustration over missing the great investment opportunity of 2009. They have said that they want to take advantage of this new great opportunity. I am with them. They are absolutely correct. The problem is when is exactly the right time to jump in?

The reality is that these markets move extremely fast. As we saw from March 18 to 26, some beaten down stocks jumped 50 per cent or more. However, in order to have achieved all of those returns, you would need to have bought in not just on the right day, but the right hour. To have purchased in that right hour, you would have needed the guts to buy when markets were in free fall. It is possible, but you need to be significantly lucky and have the willingness to go where almost nobody else is going.

On the flip side, many people think that there is another meaningful drop ahead, so they will wait for that one before buying. They may be right, but if they are wrong, then they will have almost entirely missed the ‘once-in-a-decade’ buying opportunity.

If you really want to take advantage of weak markets you have to be willing to buy in at a certain price, accept that it will likely go lower in the short term before it recovers, and keep focused on a year from now. You won’t get it perfect, but you will get it mostly right.

Health, family, friends, investments — in that order

As I mentioned at the top of the article, COVID-19 is a big threat to everyone, but it is clearly a health threat above all else. There are definitely financial fears — and for some these are pressing. Yet, for most of our clients they understand that for now, their goal is to look after themselves and each other. If they do that, everything else will take care of itself.

Several clients have had a consistent message. Their comments sound something like this, ‘We are blessed to be in Canada. We are blessed to still have reasonably good health. We have food. We have shelter. We even have spring. We are thankful to have someone like you to help with our finances, and we are not worried. This too shall pass as long as we have patience and do the right things.’

As big and as bad as this situation has become, I thank my clients for bringing their life wisdom and perspective to this time. I know that they are right and this too shall pass.

Reproduced from the National Post newspaper article 3rd April 2020.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

Investing for the Long-Term

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Long term investingOne of the things that often frustrates investment clients is the language used by investment professionals when markets go down. While the terminology is meant to soften the blow or put the current situation into context, the client is often left annoyed and confused. To help bridge the gap in understanding, I want to explain one of the main terms that you are likely to hear over the next few weeks, “investing for the long-term” or having a “long-term focus,” and why this is the perspective that clients should take during times like these.

Bull and Bear Markets

During bull markets (when stock markets are moving higher), the economy is typically growing, people are seeing their employment prospects and income increase, their assets (home and investments) are rising, so investors and corporate managers feel optimistic about the future.

The stock market is supposed to be priced on a forward looking basis. This means that the price of a stock is supposed to reflect future earnings and cash flow that the company will generate. In fact, one of the main valuation methods used is the Dividend Discount Model – a stock’s price is calculated based on future dividends investors expect to receive. During bull markets these forecasts are rosier, so higher stock prices are justified by assumptions of high growth in corporate earnings. In addition, because everyone is optimistic and does not want to miss out on the perceived easy gains, they are willing to pay higher and higher multiples to buy today.

During bear markets, as we are currently experiencing, everyone thinks of a worst case scenario. They assume that the expected economic downturn will remain for a very long period and often cannot foresee the inevitable recovery that takes place months later. As a result, they assume earnings will drop dramatically and stay low forever and therefore heavily discount the price they would be willing to pay for the same stock that only months ago they thought was a great purchase at a much higher price. In this environment, the emotion of fear and worst case scenarios are exacerbated by the negative news reports, leading many people to just want to exit the stock market no matter the price. Consequently, nearly all stocks and other risk assets (REITs, preferred shares, corporate bonds) drop in price regardless of the stability of their business model, their financial strength or if they had a reasonable valuation prior to the panic.

While I believe we are likely to have at least a technical recession in Canada (2 quarters of negative economic growth) and I think the number of cases of coronavirus and its associated stresses on the health care system and the economy, is likely to get worse in the short-term, this is the period where a long-term perspective is necessary.

What Is a Long-term Perspective?

Your investment portfolio is designed to grow not only until you reach retirement, but also to generate income (or dividends) and capital gains that will support your lifestyle in retirement. Given current lifespans, this could be 20-40 years and even possibly the lifespan of your beneficiaries, so your portfolio has a very long timeline. During periods of market declines bargains start to appear that can lay the foundations for ensuring that your long-term goals are met. I will provide a few examples below.

Canadian Banks

One of Canadians favourite pastimes is to complain about the record profits of the banks and their high service charges. Over the past few weeks, investors have only seemed to care about the risk to these banks’ loan portfolios due to the increase in credit provisions for bad loans or reduced capital market activity that occurs during recessions. Bank of Montreal (TSX: BMO) recently dropped over 40%. As a result, on Thursday, March 12th, it was offering a dividend yield of over 7% and was trading at an earnings multiple of only 7 (historical average is closer to 12 times earnings). While it is quite likely earnings will decline in the near-term, considering that the Canadian banks have an oligopoly on the Canadian financial markets and highly diversified asset bases (wealth management, lending, international operations), it is highly likely that in just a few years, if not sooner, Canadians will once again be complaining about their record profits, which will be reflected in higher share prices. On Thursday close, most of the Canadian banks were offering similar bargain prices, e.g. Bank of Nova Scotia was trading at 7.7 time earnings with a 6.7% yield. TD was trading at 8 times earnings with a 5.9% yield and CIBC was trading at 6.7 times earnings and offering an 8.4% yield. Buying in this environment provides a high current yield and likely capital gains in the future.

Pipelines

There is no question that Alberta and Saskatchewan are feeling real pain once again due to the massive price drops in oil prices from the expected economic slowdown and the game of chicken being played by Saudi Arabia and Russia, but only a few months ago the media was complaining about there not being enough pipeline capacity to handle all of the Canadian oil and gas production. In addition, hundreds of thousands of barrels of current production is being handled by higher price and less safe railway network – if there are near-term cuts, this is where it will likely come from. As a result of the current fear, Enbridge Inc. (TSX: ENB) had dropped over 35% and at end of day Thursday was offering a yield of over 9%. Enbridge has numerous projects expected to come on-line in the next few years and has provided guidance that it intends to raise its dividend each year into the near future. Other pipelines, such as Interpipeline (TSX: IPL), Pembina (TSX: PPL), TransCanada (TSX: TRP) have had similar and in some cases larger price declines with some of these companies offering current dividend yields of over 10%.

REITs

One of the more stable asset classes for income oriented investors in the past few years has been Real Estate Investment Trusts (REITs), which are actively managed portfolios of real estate holdings. Over the past few weeks, REITs have not been immune to the drop in the stock market, even though the real estate market is holding up well. As a result, many REITs have dropped 30% or more, offering compelling opportunities. For example, Northwest Healthcare (TSX: NWH.UN), which is a global REIT focused on health care related real estate (hospitals, doctor’s offices, etc.), recently saw a price decline of over 25% despite recording record profits just last week. The net asset value of the REIT’s portfolio is estimated at $13.17 per unit (35% higher than current trading price), its occupancy rate is 97.3% and the average tenant’s lease term is 14 years.1 The current yield is 8.3%, which is fully covered by the REITs cash flow. Many other REITs have seen price drops of 30% or more in the past week despite excellent fundamentals, strong management teams and a portfolio of real estate assets that would make institutional investors like pension plans salivate.

Preferred Shares

This is an asset class that is a hybrid security, meaning that it has some attributes similar to stocks and some similar to bonds. Preferred shares trade on stock exchanges, like stocks, but preferred share investors receive priority vs. equity holders in terms of dividend payments and capital protection. Unfortunately, they are also typically less liquid than many stocks and as a result do not have a lot of institutional ownership, but that also means they can and presently do trade at compelling prices. Enbridge Preferred Share Series D (TSX: ENB.PR.D) recently experienced a 35% price drop. This preferred share is a fixed rate reset, meaning that it pays the same dividend rate for 5 years and then that dividend rate is reset based on the yield of the 5 year Government of Canada bond plus a spread. As of Thursday, March 12, it was offering a dividend yield of over 11%. There is the risk that the dividend rate will be reset lower at its next anniversary date, but to put this in perspective, that date is 3 years into the future. Prior to the reset date in March 2023, an investor buying at Thursday’s closing price of $10.50 would receive $3.48 in dividends prior to the reset date and the new reset rate based on current yields would be 7.26%, still pretty high. Based on the recent price drops in the market, investors can currently buy rate reset preferred shares offering yields similar to the Enbridge example above and perpetual preferred shares, which consistently pay the same yield forever at yields of over 6%.

The Long-Term Perspective

While equity markets are likely to be volatile over the next few weeks to months and could even potentially go lower than Thursday’s lows, investors can find bargain investments similar to the ones listed above to help secure their financial future and long-term goals. For example, a one million dollar portfolio invested into some of the securities listed above would result in an annual income stream of over $70,000 plus the potential for significant price appreciation when markets return to normal. Considering that most financial plans are based on an average return of 4%-6%, this is the environment, despite the massive fear, when investors need to remain calm, not be forced sellers, and remain focused on that long-term income stream they want to support their future lifestyle.

During this period, the greatest skills your financial advisor can have are to remain calm, use a rational mind to assess the situation and clearly communicate with clients to relieve their anxiety and fear. The greatest asset a client has is time – the time to withstand this period of weakness to build a strong portfolio offering a high level of income and potential for growth.

[1] https://web.tmxmoney.com/article.php?newsid=6210584082240133&qm_symbol=NWH.UN.

 

Lorne Zeiler
Written By:
Lorne Zeiler, CFA®, iMBA
Senior VP, Portfolio Manager and Wealth Advisor
lorne@tridelta.ca
416-733-3292 x225

Are RRSPs really worth it? The answer may surprise you

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More and more people say to me that they don’t contribute to RRSPs. They don’t think it makes sense. If they ask my opinion, my response always depends on the specifics of the person who is asking. For the purposes of this article, I will address a few different scenarios.

For all of these examples, the key factors to consider are the following: In retirement, will the person likely be in a higher tax bracket than they are today, the same bracket, or a lower one? I call this the tax teeter-totter. Will their income likely be meaningfully higher or lower in the next five to ten years? How old are they? Are they married and, if so, how long will it likely be until both spouses have passed away?

Situation No. 1: Higher income, significant RRSP

This person has seen what happens when someone dies with a large RRSP or RRIF. When a single person (including widows and widowers) dies, their remaining RRSP or RRIF balance is fully taxable in the final year. For example, if their final balance is $500,000, nearly half of their account will disappear to taxes. Because of that concern, many people with a sizable RRSP and often high income decide that the RRSP isn’t a good use of their funds. To these people I say, “You are making a mistake.” If you are in a tax bracket where you can get at least a 45 per cent refund on an RRSP contribution, I say take the money today, get many years of tax-sheltered growth, and you can worry about a high tax rate on withdrawals at some point in the future. Depending on the province, this 45 per cent tax rate tends to be in place once your taxable income is above $150,000. While you could make a financial argument that it is possible to be worse off to do an (R)RSP contribution depending on what happens in the future in terms of taxes, given the certainty of tax savings at the front end, I would highly recommend making the contribution.

Situation No. 2: Lower income that could jump meaningfully in a few years, with TFSA room

RRSP Piggy BankIn Ontario, if your income is $35,000, your marginal tax rate is 20.1 per cent. If your income is $50,000, your marginal tax rate is 29.7 per cent. If you are making $35,000 today, but think you might be making $50,000+ in the next couple of years, it is better to put any savings into a TFSA now, and wait to do the RSP contribution until you are making $50,000. This is the situation for many people early in their careers. You will be making almost 10 per cent more guaranteed return (29.7 minus 20.1) by waiting, but will still have the same tax sheltering in the TFSA as you would in the RRSP. In general, if you think you will likely be in a much higher tax bracket in the near future, it is better to hold off RRSP contributions, and save up the room to use when you will get a much bigger refund. As a rule of thumb, I suggest people with a taxable income under $48,000 put any savings into a TFSA before putting it into an RRSP.

Situation No. 3: Income could fall meaningfully in a few years

This is the opposite situation and recommendation to No. 2. If you think that you will be in a much lower tax bracket in the near future (taking time off work for whatever reason), you may want to put money in the RRSP now, and actually take it out in a year when your income will otherwise be very low. Many people do not realize that you can take funds out of your regular RRSP at any time and at any age. While you will be taxed on these withdrawals as income, if the tax rate is very low because you have little other income, it usually makes sense to withdraw the money in those years and put it back when your income is much higher.

Situation No. 4: Couple in late 60s, not yet drawing from RRIF

Some people figure that there is no point to put money into an RRSP in their late 60s because they are just going to draw it out shortly anyways. It is true that one of the values of tax sheltering is the compounding benefit of time. Putting a dollar into an RRSP at age 30 will likely have more of an impact than at age 68. Having said that, often people forget that even if they start drawing funds out of a RRIF at 72 or earlier, they may very well still be drawing out funds 20 years later. There is still many years of tax sheltering benefit. The question goes back to the tax teeter-totter. If they are going to get a 25 per cent refund to put funds into their RRSP, but will be getting taxed at 30 per cent or more when they take it out, then it probably doesn’t make sense to contribute more to their RRSP. It all comes back to their likely income and tax rates once they start to draw funds down from their RRIF.

Situation No. 5: Husband is 72, wife is 58

The answer to the question of how to contribute to an RRSP for couples with a significant age difference depends on the taxable income of each person and the ability to most effectively split income over the next number of years. Larger age gaps can be quite valuable for RRSP investing. One reason is that if the younger spouse has a Spousal RSP, and the older spouse still has RSP room, the older spouse can contribute to the younger spouse’s Spousal RSP. This can be done by the older spouse, even if they are older than 71, as long as the younger spouse is below that age. In this example, if the 58-year-old isn’t working, she can actually draw income out from their Spousal RSP and claim the funds only as their income, even though the 72-year-old had benefitted from the tax advantages of contributing over the years. As a reminder, if the younger person had a large Spousal RSP and the older one had no RSP or RIF, they wouldn’t be forced to draw any income because the younger partner was not yet 71. The one area to be careful of is that for the income to be attributable to the 58 year old and not the 72-year-old, there can’t be any contributions to the Spousal RSP for three years. To take advantage of this scenario, maybe the older partner contributes for many years to the Spousal RSP, but stops three years before the younger spouse plans to draw the funds.

While the RSP is generally a positive wealth management tool for many Canadians, there is a time to contribute, there is a time not to contribute and there is a time to withdraw funds. Each situation may create opportunities to maximize your long-term wealth. Choose wisely.

Reproduced from the National Post newspaper article 19th February 2020.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

This borrow-to-invest strategy can build you wealth with someone else’s money

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“Borrowing to invest” can be a scary phrase. There have been many inappropriate cases where it doesn’t end well.

Yet for all of the naysayers, I am pretty sure that you are currently doing it or have done it before.

If you have ever had a mortgage or debt on a home equity line of credit, you have borrowed to invest — you were taking on extra debt to invest in a house. Houses can go up or down in value, yet you probably didn’t consider this to be similar in risk to “borrowing to invest.”

If you contribute to or receive Canada Pension Plan (CPP), then you are also, in a way, borrowing to invest. The CPP, like most large Canadian pension plans, now uses some form of leverage or borrowing to try to outperform their benchmarks.

To start off, it is important to remember that borrowing to invest adds risk. There is no getting around that. Having said that, investing in anything other than cash adds risk. Some would say that even holding cash has risk from an inflation and currency perspective.

My view on leveraged investing is that if you are going to consider it, you want to do your best to minimize the risks and try to lock in, as best as possible, a spread between your borrowing costs and your investment return. You also need to factor taxes and deductibility into the strategy.

The strategy

There is an opportunity today for certain people to profit from the gap between the lower borrowing costs for those with a home and great credit and the higher borrowing costs that others might be paying even when their loans are fairly well secured. Essentially you would be profiting from the gap between your good credit and someone else’s weaker credit.

Here is a current approach that I would support for the right individual.

Step 1: Borrow at the lowest possible rate

Today that would mean borrowing through a mortgage. You can lock in a five-year mortgage at a rate between 2.50 per cent and 3.00 per cent if you have good credit. These figures are approaching historical lows for fixed five-year rates. At such a low rate, you are meaningfully increasing the likelihood that a borrowing to invest strategy will be profitable for you.

Step 2: Find investments that provide a high income yield and low volatility

Today, most of the investments that we find that meet these criteria would be in the private debt space. Whether it is in mortgages, business lending, factoring or other specialized debt, we have found many investments that have been paying out steady returns in the seven per cent to 10 per cent range. It doesn’t mean that there is no risk here. There are risks in all of these investments, but we believe that under most scenarios that these returns should stay stable. If someone wanted more investment diversification, other investments that we would consider might include some REITs, utilities and perpetual preferred shares that would have yields in the four per cent to 6.5 per cent range that would minimize some of the underlying volatility.

Step 3: Do the math

Let’s now look at the math if someone borrows $100,000 to invest for five years.

On a 2.75 per cent mortgage with a five-year fixed rate, each month’s payment would be $461.31. Over five years, $14,913.40 in principal and $12,765.25 in interest would have been paid, for a total of $27,678.65. At the end of 5 years, the remaining debt owing will be $85,086.60. For the purposes of this analysis, we will assume that the monthly mortgage payment will be drawn out of the investment pool, but while this is a slight drag on performance, to keep the complexity down we will assume that this draw doesn’t impact total return.

On the investment front, there isn’t the same certainty as the lending side. An example in the private debt space that we use would be the Trez Capital Yield Trust, which invests in U.S. mortgages (as they have a low correlation with Canadian Real Estate). The Canadian dollar hedged version did 9.9 per cent annually over the past five years, although we wouldn’t expect returns that high over the next five years. Outside of private debt, the TSX Capped Utilities index had a five-year annualized return of 7.79 per cent to June 30, 2019. The TSX Capped REIT index did 7.80 per cent. TSX Canadian Financial Monthly Income did 5.64 per cent. All three of these had higher returns in the prior five years from 2009 to 2014. While there are no guarantees, let’s say we had a 7.5 per cent return on these investments.

Let’s assume this individual has $100,000 of income, lives in Ontario and in one version pays 1.5 per cent in investment fees to an investment counsellor, and in another does it themselves.

On the surface, someone is earning 7.5 per cent and is paying interest of 2.75 per cent, which leaves a spread of 4.75 per cent per year for five years. Of course, it isn’t that simple.

We need to factor in taxes and fees. I will keep it simple but want to highlight a few important points.

First, interest on the mortgage is fully tax deductible because you are borrowing funds to invest in a taxable account.

Second, investment counselling fees would be fully tax deductible if the investments are being done in a taxable account.

Given the individual’s income, their marginal tax rate is 43.41 per cent.

Based on my calculations, if the investment returns were all treated as income (this is the worst-case scenario) they would earn 7.5 per cent and then be able to deduct the 2.75 per cent of interest on the mortgage and then deduct the 1.5 per cent for investment counselling fees.

If they are taxed at 43.41 per cent on the remaining 3.25 per cent, they will keep 1.84 per cent after tax. If they were comfortable doing this all themselves and paid no investment management fees they would be at 2.69 per cent. This is based on 7.5 per cent return minus 2.75 per cent interest, leaving 4.75 per cent. After 43.41 per cent tax, this would leave 2.69 per cent.

Those numbers may not seem huge, but they can add up quickly.

Over five years, on $100,000 at 1.84 per cent, that would be $9,200 in after-tax dollars with no compounding. On a pre-tax basis, you would need to earn $16,257 to get $9,200 after tax. Keep in mind that this is wealth that was created with someone else’s money.

If the same scenario used $250,000, it would be $23,000 in after-tax money or $40,643 of pre-tax income.

If the same scenario used $500,000, it would be $46,000 in after-tax money or $81,286 of pre-tax income.

Managing the investments yourself, having returns that consist in part of capital gains or Canadian dividends instead of income, and reducing your borrowing costs below 2.75 per cent can all boost the returns you can earn from this strategy.

It is important to remember that none of the returns described here can be guaranteed.

There are some risks, but if they are kept low, this strategy has the potential to be a powerful method of adding wealth using someone else’s money.

Reproduced from the National Post newspaper article 6th August 2019.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

What Happened to the Preferred Shares Market?

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The stock market suffered a big market drop in the Fall / early Winter, but has since had a substantial recovery. Bonds posted solid returns this past year. Preferred shares have had a very different experience. They declined last year, had a modest recovery and have sold off again in the past few months, leaving many preferred share investors wondering what has happened to the preferred share market and will it ever recover.

The Past Year

Preferred share returns have been anything but preferred over the past few years. In the past 12 months to May 31, the BMO 50 Preferred Share Index has declined by nearly 13.5% on a total return basis (including dividends received), with Fixed Rate Resets down 15%, Floating Rate Preferreds down an incredible 27% and only Perpetuals providing a positive return of 4.3% (price only return is still -1.3% for the past twelve months). On a five year basis, preferred share returns, including dividends have been essentially flat, but on price alone basis, preferred share prices have dropped nearly 23%. Fixed Reset preferred shares have seen their prices drop by over 30% in that same period.[i] Weren’t these investments supposed to be safer than stocks? Does it make sense to still hold them and when can investors expect a positive return?

Preferred Share Structure

Preferred shares are considered to be a hybrid security as they pay a fixed coupon payment (although sometimes the coupon payment is reset at specific intervals) similar to bonds. They also rank between bonds and equity in terms of security, i.e. a preferred shareholder is paid out after the bondholders, but before equity holders and preferred shares offer daily liquidity as they trade on the stock exchange (TSX). For these reasons, they were considered safer and less volatile than equity, but not as safe as bonds.

For many years, preferred shares were an income focused investment that either paid a consistent dividend amount (perpetuals) or the dividend amount changed with short-term interest rates (floating rate). These preferred shares offered a higher yield than equivalent bonds, but the yield premium today is substantially more than it has been historically. Many perpetual preferred shares are paying yields of 5.5%, a 3.8% premium over 30 year Government of Canada bonds that yield only 1.7%.

Things changed dramatically in the preferred share space when fixed reset preferred shares entered the market. Fixed rate reset preferred shares, which pay a fixed dividend rate for 5 years from date of issue are structured in the issuer’s favour. On the 5 year anniversary date, the dividend rate is reset based on the yield of the 5 year Government of Canada bond plus a specific premium yield that was set out at inception. But, if yields have gone up or if the issuer can finance at a cheaper rate, the preferred share can be called at par value.

The rate reset preferred shares became very popular with investors following the 2008 financial crisis, as they were looking for shorter-dated, higher yielding hybrid securities. Fixed resets now comprise approximately 75% of the entire preferred share market.

Many investors thought in 2008 – 2010 that they were buying a 5 year fixed rate preferred share, either not understanding or caring about the rate reset structure. In many cases, these preferred shares may have been mis-sold as 5 year fixed investments without contemplation of the risk that the dividend rate could be reset lower (reset risk) on the anniversary date.

In late 2014-2015 when oil prices cratered, Alberta went into recession and the Bank of Canada cut interest rates, many rate reset preferred shares dropped substantially in price. For example, a preferred share with a 5% yield, but with a rate reset formula of 5 Year Government of Canada plus 2%, saw the new dividend rate drop to 3% or less as 5 year government of Canada bond yields slipped below 1%. Prices on some rate reset preferred shares dropped over 30% within a year. While prices of rate reset preferred shares did go up when the economy started to improve and bond yields started to climb, the sheen had come off rate reset preferred shares.

This Last Year

There have been a few causes for the drop-off in preferred shares over the past year, but the drop has likely been too far and too fast, making many preferred share bargains, offering fairly high yields and the potential for price appreciation (see chart). The causes for the drop are below.

Bond Yields: The biggest investment change over the past year has been the shift in sentiment about interest rates. Early in 2018, the question was how many more times rates would rise and the yield curve reflected this. For example, 5 Year Government of Canada bonds were yielding 2.1% one year ago, but only about 1.35% presently. The yield curve has inverted for much of 2019. This is a scenario when longer-term interest rates are lower than short-term rates. The inverted yield curve often indicates that rate cuts are expected in the short-term and that the economy is slowing. Yet in this environment, stocks have gone up, bonds have gone up, while preferred shares have sold off dramatically.

As investors are supposed to be forward-looking, many have demanded higher current yields for their preferred shares, particularly rate resets, to offset the potential risk that the dividend rate will be reset lower. In many cases, the price drop has been overdone. Enbridge preferred share series D (ENB.PR.D) has seen its share price drop by over 20% in the past year. Yet, its dividend will not be reset for nearly 4 years and is currently paying a yield of 7.2%, nearly 6% higher than the 5 year Government of Canada bonds.

Index Funds: ETFs (Exchange Traded Funds) offer many advantages to investors, such as low cost, liquidity and diversification, but many investors assume that the underlying investments within the ETF are just as liquid as the ETF itself. In the case of preferred shares, this belief is wrong. Preferred shares are often smaller issues of $200 million or less and since many investors have a buy and hold mentality, they do not necessarily trade much. When preferred share ETFs experience sell-offs, the underlying preferred shares have to be sold down, regardless of price. This can make a small decline in the market much more substantial.

Investors Fleeing the Asset Class (Once Bitten, Twice Shy): Many investors who lost money in 2015 on preferred shares have decided to sell their remaining preferred shares or to simply avoid the asset class, by allocating their money to stocks and bonds instead. The last time preferred shares experienced this huge sell-off, institutional investors, like pension funds, began to buy into the market. So far, these investors have not yet returned to this asset class, but at some point low prices and high yields should attract greater interest.

Are Preferred Shares Worth Buying Today?

In general, I think the answer is yes, but some areas offer more compelling value.

Perpetual preferred shares – As mentioned previously, these preferred shares pay the same rate in perpetuity with no risk of the rate being reset. The vast majority of issuers are high quality, investment grade companies, such as the Banks, Life Insurance companies, and Utilities. While their sell-off has been much less than other parts of the market, their prices typically go up when bond yields are dropping, as the consistent high dividend rate should be of greater value to income investors in a low rate environment. For example, as 30 year bond rates have dropped over 0.5% in the past year, long-dated fixed income investments should have experienced price increases of over 10% based on financial math.

As a result, many of these perpetual preferred shares are offering dividend yields of well over 5%, a premium of over 3.5% vs. government bonds. Considering that many investors who are in or near retirement need income from their investments and are targeting return rates of 4% – 6% in their financial plans, shouldn’t an investment that pays consistent, tax-advantaged dividends at a rate of between 5%-6% be in high demand? Yes. They should. For long-term income investors, these preferred shares offer yields high enough to meet their spending needs and an opportunity for capital appreciation.

Deep Discount Rate Reset Preferred Shares. The rate reset market, which has caused most of the problem, also offers great opportunities. Currently, there are many rate reset preferred shares offering yields of 6.5% or more, are likely 3 or more years away from being reset and are likely to be reset at similar or higher rates, so you are getting more than fairly paid for the interest rate risk.

Selected Opportunities in Perpetual Preferred Shares

ISSUER Current Yield [ii] Premium over Bonds [iii]
WN.PR.D (George Weston) 5.5% 3.8%
BAM.PR.N (Brookfield Asset Management) 6.0% 4.3%
ELF.PR.F (E-L Financial) 5.5% 3.8%
IFC.PR.F (Intact Financial) 5.5% 3.8%
SLF.PR.D (SunLife) 5.5% 3.8%

 

Selected Opportunities in Rate Reset Preferred Shares

ISSUER Current Yield Premium Over Bonds [iv] Reset Date Projected Reset Rate [v]
BPO.PR.T (Brookfield Properties) 7.6% 6.3% Dec. 2023 6.3%
ENB.PR.D (Enbridge) 7.3% 6.0% March 2023 6.0%
FFH.PR.E (Fairfax Financial) 5.4% 4.1% March 2020 6.5%
NA.PR.S (National Bank) 5.8% 4.5% May 2024 5.3%

 

Preferred Share – Case to Buy Them Today

Warren Buffet has often said that the key to investing is buying good companies at fair prices. I believe anytime that you can invest in high quality assets at a cheap price is equally effective. Preferred share issuers are typically investment grade companies, so there is limited credit risk. The dividend payments rank in priority to equity holders and most importantly, they are trading today at substantial price discounts relative to the yield premium investors can collect over bonds. Perpetual preferred shares are paying premiums of nearly 4% over long dated bonds. Typically, this premium is closer to 2%. Rate resets do carry some interest rate risk but that can be reduced substantially by buying issues with different maturity dates while investors can collect premiums of 5% or more over bonds.

In late 2008 through 2009, I bought preferred shares for myself and my clients to earn a high dividend rate with minimal risk of default based on the high quality of the issuers. I also figured that there was a good chance for price appreciation when more normal market conditions returned. By 2011, many of those preferred shares were up over 20% and had paid over 10% in dividends. Preferred shares are unloved today, but definitely offer significant value and a high rate of tax advantaged income. Income investors who do not own them, should definitely consider adding preferred shares to their portfolios, while those that do own them presently will continue to receive high levels of income and may be rewarded for their patience.

[i] Source: BMO CM 50 Preferred Share Index – May 2019. BMO Capital Markets
[ii] Based on June 18, 2019 market prices
[iii] 30 Year Government of Canada Bond
[iv] 5 Year Government of Canada Bond
[v] Based on 5 Year Government of Canada Bond at June 18, 2019 and reset spread

Lorne Zeiler
Written By:
Lorne Zeiler, MBA, CFA
VP, Portfolio Manager
lorne@tridelta.ca
416-733-3292 x225

Financial Post/Rechtshaffen: How wealth advisors provide a significantly higher value service for core clients than roboadvisors

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Advisors know which clients to put on which path to achieve the best big-picture result

Several people have asked me lately about the Questrade TV ads that feature someone in their 30s going to what appears to be their parents’ financial advisor to tell them why they are leaving. My first thought was, “Why did they visit an advisor they don’t like, in one case even bringing their baby, just to say that they are leaving — who has time for that?” My bigger thought was that the ads underscore how different my job is to what services such as Questrade do.

The first thing to remember is that different people have different needs at different stages of their life. Where a good wealth advisor can provide significant value to a 75-year-old couple with decent wealth and a complicated family situation, they may not be able to add nearly as much to a 40-year-old couple who are simply working and putting away a little each month. The best case for all involved is to have an individual with a financial need that fits well with their provider, whether that is a computer, a bank branch, or a highly specialized wealth advisor.

In our business, we find that we provide a good fit for two core groups of people. The first are those who are retired or in a transition from being employed to being retired. Much of the work we do relates to how best to draw on funds when the paycheque ends, being tax efficient and generating sizable investment income along the way (regardless of stock market performance). It would also include developing strategies that start with a likely estate value and working backwards to determine how you best want to live the last major period of your life and what legacy is important to you. This list of issues is very different from the typical experience with a low-fee online brokerage.

The second group are those with high incomes, both employees and those with corporations. There remain a few approaches to truly help these people on the tax front both on an annual basis and for the rest of their lives. Taxation often plays a large role in their investment decisions, and unique strategies are often key to providing them the type of value they are most looking for. Again, these individuals are often missing out on the bigger picture if they are going to simply find the cheapest online provider.

When I think about the areas of greatest value that a good wealth advisor can provide, they rarely relate directly to the best investment returns or the lowest fees. They usually come down to how you can help someone to have a better life because of the advice they receive. These issues come down to four key areas. These will not apply to everyone. Some people are in better financial positions than others, but most still bring some level of financial stress and worry. The four areas are:

Reducing financial worry and stress

This often starts with showing someone what their financial future will very likely look like on an annual basis and giving them the comfort that they will not outlive their money. It may also provide a financial stress test to show that under some less-than-ideal scenarios, they still will likely be OK. This plan will help them answer questions around whether they can help their children and still be in good shape, or whether they can afford to do something that is important to them. Sometimes this will show them the opposite, and will create the need for either lowering expenses, the possibility of finding additional income, or developing some other plan. In cases where there is more than sufficient assets, this foundation often opens the door to the “what to do next” discussion.

Teaching people how to spend their money

For many who lean toward being savers with their money, it can be very difficult to change this habit even if the facts show that they will have a lot of money that they never spend in their life. This can be especially important in changing their lifestyle in early retirement years of good health. Helping people to spend more, do more and take advantage of the maybe five, 10 or 20 years of decent health in retirement can be one of the most rewarding parts of our job. It can also have a big impact on improving someone’s life.

Leaving a clear and structured family legacy that provides peace of mind

This is extremely important for those with a child or grandchild that may not be able to become financially self-sufficient. In addition, there are increasingly families with second and third marriages and myriad stepchildren. Navigating these waters successfully can be crucial to how someone is remembered by family for generations to come. Often, these issues weigh heavily on people’s minds, and having someone who can help them create a plan to look after these issues can be the biggest value an advisor can provide. As one of my older clients recently told me, “I hope I live to be 100, but if I don’t make it and something happens to me now, I know that everything has been taken care of and that I am leaving my family in good shape.”

Leaving a meaningful charitable legacy that enriches a person’s life

For those that are projected to have a larger estate than what they want to leave to their family, charitable giving is often part of their plan. The earlier someone is aware of this scenario, the better they can plan in order to provide the greatest gift for the least amount of after-tax dollars. It also may provide great personal joy and satisfaction from knowing the impact they are having on a charity while they are still alive.

While there are many people who may not be a fit for some or all of the four key areas above, that is OK — they are likely a fit for a different part of the financial world.

However, when someone asks me about whether Questrade and their TV commercials affect my business, I just think about how different the issues I deal with are from what most people want from a roboadvisor or direct broker.

Reproduced from The Financial Post – June 3, 2019.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221
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