Gentlemen Prefer Shares Split Shares - himivest.com

1 Canadian MoneySaver PO Box 370 Bath ON K0H 1G0 (613) 352-7448 NOV/DEC 2006 Gentlemen Prefer SharesSplit SharesJames HymasA reader of this column asked for an explanationof Split share corporations and their suitabilityfor preferred share investors, so I ll be devotingthis column to this particular class of that you like bank stocks, for example. Forwhatever reason, you feel that financial equities are on theirway up and you re prepared to back up your beliefs withsome money. The most straightforward way to do this is,of course, simply to buy some bank stocks, but we ll as-sume for now that this is not considered to be a viable op-tion you, as a small investor, feel at lot more comfortableif you have professional management of your , given that you are comfortable with your view thatfinancials will go up, but uncomfortable with the notion ofdirect investing, your options are: Buy a mutual fund specializing in financials, or Buy an exchange-traded index fund devoted to the financials re very comfortable with the idea that financials areon their way up so comfortable that you are willing toleverage your bets.

2 Again you have a straightforward op-tion: you can just do whatever you were going to do inyour cash account, but more of it in your margin will involve borrowing money from your brokeragefirm, however, and a lot of people aren t comfortable withsuch an arrangement. Why not get the professionals to bor-row for you?The friendly underwriters on Bay Street have anticipatedyour need and have invented Split share corporations .These corporations are set up so that an investment portfo-lio can be held by the firm, paid for partly by ownershipand partly through borrowing and are thus, in essence,closed-end mutual funds that employ leverage. Many ofthe corporations will attempt to add a little extra returnthrough such techniques as covered call writing and cashcovered put writing , but these embellishments are not ourconcern at the moment.

3 We re fixed-income investors, notoption-strategy CREDIT CHARACTERISTICS OF THE Split Shares EXAMINEDDate ofCommonPreferredPreferredDBRSA nnualEquityShareAssetNet NormalShareIncomeCreditReport(thousands) CapitalCoverageIncome**DividendsCoverage RatingTickerExamined$(thousands)Ratio(th ousands)(thousands)Ratio(Sept 2006) $709,737$152, :114,185$8, *12/31/2005588,146135, :16,7286, ,34784, :13,6744, ,200125, :16,6007, ,50667, :12,5103, ,021109, :14,2445, ,50048, :11,2432, ,437289, :110,26416, ,09747, :12,8251, :1 Pfd-2(low) ,300163, :14,6909, :1 Pfd-2 Note: The annual reports examined are all relatively dated at this time readers are urged to obtain more recent financial data prior toconsidering the possibilities for investment.*Note particularly that there has been a new issue of preferred Shares by this issuer subsequent to the annual report examined.

4 ** Normal Income , as used in this table, refers to income before accounting for realized/unrealized capital gains/losses on both equities andoptions and performance fees. The inclusion of option premia received in Normal Income would increase the calculated Income CoverageRatio .Canadian MoneySaver PO Box 370 Bath ON K0H 1G0 (613) 352-7448 NOV/DEC 2006 The professional money managers who promote and op-erate the Split share corporations have a number of alterna-tives when deciding how the portfolio is to be funded. Theycould simply borrow money from a bank, but this is not anoptimal strategy. The underlying investment portfolio isgoing to paying dividends perhaps a relatively largeamount of dividends, if the portfolio is invested in Cana-dian bank stocks, or perhaps a lesser amount, if the portfo-lio is roughly matched with the from the May 2006 issue of Canadian MoneySaver,that the dividend tax credit and gross-up had the effect ofmaking dividends more valuable than interest while cor-porate bonds had a higher pre-tax total return, preferredshares have historically outperformed on an after-tax fact, with the latest changes to the tax regime in On-tario, an investor in the top tax bracket needs to get $ interest in order to have the same after-tax income as asimilar investor getting $ in dividends.

5 Dividends aregood things! They bring with them an enormous tax ad-vantage! Never forget that!If these corporations borrow money and pay interest onthat money, they lose all the tax advantages that would other-wise accrue from the receipt of dividends from their invest-ment portfolio. It would be much better for investors in gen-eral (and correspondingly bad for the tax collectors) if thecost of the funds borrowed to leverage the portfolio could bepaid in a tax-advantaged way, with the dividends from theinvestment flowing through to the lender. And this is exactlywhat happens with most Split share corporations: the moneyused to leverage the capital investment is raised through apreferred share issue and, to a greater or lesser extent depend-ing on the company, dividends from the underlying invest-ment cover the dividends on the daily commentary at re-ports on the characteristics and performance of a numberof preferred share indices, each index representing a differ-ent class of issue.

6 One of these indices reports on Split sharepreferreds that: Are included in the universe analyzed by HIMIPref ,my firm s analytical software, and Are rated Pfd-2(low) or better by DBRS (see ), and Have an average daily trading value of $25,000 or more(the calculation of this value is subject to various con-straints and adjustments).These restrictions reduce the number of qualifying is-sues to ten, as of the re-balancing at the end of issues are listed in the table Issues Included in theHIMIPref Split Share Index; with more informationsummarized in the table Some Credit Characteristics ofthe Split Shares Examined .These characteristics include the two ratios that are thebackbone of credit analysis: income coverage and assetcoverage . The former value has been defined for the pur-pose of this article as including only normal income sincecapital gains, both realized and unrealized, are too unpre-dictable to be worthy of notice.

7 In essence, income cover-age shows the relationship between cash that may be rea-sonably expected to come in and cash going out .. if lessthan :1, the company is reliant upon its other incomeISSUES INCLUDED IN THE HIMIPref Split SHARE INDEXT ickerInvestment ManagerBase Investment Investment Management Large capitalization Canadian equityPassive management against custom Meighen & AssociatesDiversified stock portfolioActive management of stock of 15 Canadian dividend-paying stocksMay write covered call options; stock portfolioActive management of stock of 10 Canadian and 5 American financialMay write covered call options; performanceservices of 10 Canadian and 5 American financialMay write covered call options; performanceservices American financial services companiesMay write covered calls; performance 5 Canadian BanksMay write covered calls and Securities Bank stock capitalization financial equitiesMay write covered calls and : SOME HISTORICAL DATADateAsset CoverageDBRS Rating12/31 :1 Pfd-212/31 :1 Pfd-212/31 :1 Pfd-212/31 :1 Pfd-312/31 :1D12/31 :1D12/31 :1D12/31 :1D9/30 :1 DAsset coverage calculated from information at rating from information at MoneySaver PO Box 370 Bath ON K0H 1G0 (613) 352-7448 NOV/DEC 2006(capital gains, option writing, etc) to pay thepreferred share dividend, or may have to dipinto capital to meet these payments.

8 Assetcoverage shows the ratio between what thecompany owns against what it owes (for exam-ple, a 75% mortgage in the absence of any otherinformation, can be viewed as having a 100:75,or :1 asset coverage ratio). In both cases,higher ratios are better than lower major problem with the Split Shares sub-class is the dependence upon financial assets and,in many cases, the narrowness of this asset may hypothesize from the characteristics table (and confirm from the actual DBRS re-port) that , with its entire value de-pendent upon the performance of TD Bankequity, is considered less creditworthy thanmight otherwise have been the case due to thenarrowness of its asset base. As so often with investing, di-versification is a means to safety!Which brings to mind a cautionary tale illustrating theAchilles Heel of Split Shares : Mulvihill Premium GlobalTelecom Fund, / The underlying asset forthis investment is telecom Shares .

9 With the benefit of hind-sight we know that this wasn t exactly the best asset class todepend on during the Tech Wreck, but comparing the as-set coverage in 1998 to those shown for the current qual-ity Split Shares is a sobering experience. Research using theHIMIPref database has shown a higher potential for creditdowngrades with Split Shares as opposed to issues of oper-ating companies, so investors must be careful, be alert andbe the sufficient risk of a downgrade of Split sharecorporations preferred Shares , for me to mention it in sucha short article, why invest in them at all? Three major pointsshould be considered: There is a possibility of credit impairment with any is-sue, not just with Split Shares . Split Shares are always retractible (see Perpetual andRetractible Preferred Shares in the June 2006 issue ofCanadian MoneySaver), a trait desirable for many port-folios, which also means that a limit exists on how longinvestors must assume credit worthiness of the invest-ment.

10 Note: I consider a set maturity date to be equiva-lent to retractibility for risk management purposes. The yield is generally higher on Split share preferreds, asshown by this article s so this article ends, with an exhortation that will befamiliar to regular readers: there s good yield available but,as with any other investment, check things out for your-self or ensure that your advisor has done the checking prior to committing Hymas, CFA, Hymas Investment Management, 129 Humbercrest Blvd, Toronto, ON, M6S 4L4 (416) 604-4204, James specializes in preferredshare analysis.