A new thought on diversification: Add some guaranteed money to your portfolio.
Guaranteed investment certificates offer as much as 5.5 per cent for one year and 5.4 per cent for two years, which looks just fine right now with both stocks and bonds stumbling. A sprinkling of GIC money in a portfolio takes the edge off.
This year was shaping up not too badly for stocks and bonds until a report last week that showed U.S. inflation isn’t backing off as hoped. The resulting higher-for-longer interest rate outlook sent both stocks and bonds lower, yet another reminder of the limits of traditional diversification.
Bonds are supposed to offset the risk of losing money in stocks, and generally they’ll do this over a lifetime of investing. But inflation is a unique problem. It drives down bond prices and weighs on stocks as well right now. The longer rates stay high, the more chance there is of a recession that slashes corporate profits.
Falling stocks present an opportunity for long-term investors to buy at reduced prices. But waiting for your buy-low strategy to pay off can be nerve racking if stocks fall further. Bonds might normally stabilize a portfolio, but that’s not happening now. This brings us to GICs.
Few investors will reach their financial goals with a GICs-only strategy. But adding some GICs to a portfolio to ride shotgun with your bonds can help you in two ways. One, you lock in an inflation-beating return around 5 per cent for one or two years, which should stand up well. Let’s be honest about diversified balanced portfolios - a return of 5 to 6 per cent after fees is a reasonable expectation over the decades.
Two, GICs inject calm into a portfolio. Whatever else is going wrong, they deliver their interest with no stress or distractions. If you have a mix of 60 per cent stocks and 40 per cent bonds, 10 or 20 percentage points on the bond side could go into GICs. Consider a three-year ladder of GICs, which means equal investments in terms of one, two and three years.
GIC interest is taxed like regular income, but so is bond interest. Bonds can also deliver capital gains if their price rises, which is something that GICs cannot offer. The flip side is that bonds can fall in price, while GICs hold steady.
Falling stocks should tempt you to buy stocks, not GICs. But with all the uncertainty in the financial world today, having a slice of your portfolio devoted to GICs makes some sense.
-- Rob Carrick, personal finance columnist
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Ask Globe Investor
Question: What’s your opinion of Financial 15 Split Corp. (FTN-PR-A-T), which pays about 9 per cent in yield?
Answer: Financial 15 Split invests in a basket of Canadian banks and insurers, plus a handful of U.S. names.
Split corporations issue two types of shares to the public: preferred shares and capital (or class A) shares. The preferreds are more conservative, because they have first claim on the dividends from the underlying stocks. The preferreds also get first dibs on the capital of the portfolio, up to the preferreds’ issue price (of $10 a share in FTN.PR.A’s case), upon termination of the split share corporation.
Split capital shares, on the other hand, are much more volatile. Because they are entitled to all of the value in the portfolio above the amount allocated to the preferreds, the class A shares are in effect a leveraged play on the underlying stocks. If the portfolio rises in value, the capital shares will post an even bigger gain. But if the underlying stocks fall, the capital shares will suffer an even bigger loss. Capital shares often pay dividends as well, but these can be suspended if the total value of the split corporation falls below a certain threshold. That’s what happened in 2020, when Financial 15 Split’s class A shares skipped dividend payments for nine consecutive months.
In contrast, split preferred dividends are generally safe. In FTN.PR.A’s case, however, there’s an added wrinkle: The manager, Quadravest Capital Management Inc., has hiked the dividend on the preferreds three times in the past four years, by a cumulative 68 per cent. That’s an enormous increase, and it’s the reason the preferreds now yield north of 9 per cent, based on annualizing the most recent monthly dividend.
“I believe that Quadravest boosted the preferred share dividend to such a high level because they wanted to keep the preferred share price high” to facilitate the sale of additional shares through the company’s “at-the-market equity program,” James Hymas, president of Hymas Investment Management Inc., said in an e-mail. The ATM, which the company renewed in December, allows Financial 15 Split to issue shares to the public from time to time at the company’s discretion.
But here’s the thing: The dividend – which is currently about 7.7 cents a month or 92.5 cents annually – won’t necessarily remain at its current level forever. The dividend rate is set annually at the discretion of the board and is subject only to a minimum yield of 5.5 per cent until 2025, when the split corporation is scheduled for termination on Dec. 1 of that year (subject to a further five-year extension).
If Quadravest were to cut the preferred dividend to the minimum of 5.5 per cent (based on the issue price of $10) in December, 2024, investors who hold the shares from now until maturity in December, 2025, would have an effective annual yield of just 6.75 per cent, Mr. Hymas said.
I’m not saying Quadravest will cut the dividend, just that it is a possibility.
Reflecting this and other risks, DBRS Morningstar this week downgraded FTN.PR.A’s shares to Pfd-4 (high) from Pfd-3. Preferred shares rated Pfd-4 “are generally speculative, where the degree of protection afforded to dividends and principal is uncertain, particularly during periods of economic adversity,” the rating agency said.
DBRS Morningstar cited, among other factors, FTN.PR.A’s recent dividend increase in December and a decline in the dividend coverage ratio to 0.37 times, meaning the dividends generated by the underlying portfolio of stocks cover just 37 per cent of the payout to preferred shareholders.
“To supplement the portfolio income, the company may engage in covered call options and put option writing on all or a portion of the shares held in the portfolio,” DBRS Morningstar said.
Bottom line: Before you stuff your portfolio with high-yielding securities, remember that there is no free lunch with investing.
--John Heinzl (E-mail your questions to jheinzl@globeandmail.com)
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Compiled by Globe Investor Staff