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How to get a perpetual seven per cent return on your investment capital

Alan MacDonald

Many investors these days are wondering how they can capitalize on the incredible run-up we’ve been seeing in interest rates lately. According to the RBC Strategy Committee, the current high rates will probably be with us for a while. But with ongoing secular forces like an aging workforce still hard at work behind the scenes to push rates back down, our future will likely eventually look more like Japan or Europe, where interest rates have been consistently low for decades.

So, if today’s rates won’t be around forever, what can the average investor do to capitalize on the current high-rate environment? One way you can lock in today’s high rates of return forever is by adding some perpetual preferred shares to your portfolio.

Preferred shares are different from common shares, which are the shares most people are familiar with. Common shares represent an ownership stake in a company and generally tend to increase in value when corporate earnings go up. Preferred shares, on the other hand, represent an obligation on the part of the company that issues them.

Unlike with dividend-paying common shares, preferred shares don’t get dividend increases or any other kind of profit-sharing bonuses when a company’s bottom line improves. Instead, the company simply pays the fixed preferred share dividend, and that ends their obligation to their preferred shareholders.

Where the “preferred” part of preferred shares comes in, however, is that preferred shares have “first dibs” on all the dividends that get paid. This means that when a company’s earnings aren’t doing so well, preferred share dividends will still get paid out in full first, even if it means that the issuing company won’t have anything left to pay out any common share dividends.

Right now, for example, you can pick up an “R” series preferred share from Great West Life that will pay out an annual dividend of 7 per cent, and that dividend will be fixed at 7 per cent in perpetuity, regardless of whatever else is happening in the economy. With our current high interest rates, there are a few perpetual shares available right now in different sectors of the economy that are offering yields of 7 per cent or even higher, which would allow a yield-hungry investor to put together a nicely diversified portfolio.

Perpetual shares can, in certain circumstances, be bought back by the issuing company. But to do so, the issuer must pay the par value of the stock, which today is generally much higher than the market price. For those Great West Life R-series shares, for example, the buy-back price would be $25 – a substantial premium over the current trading price of $17.18 a share.

Given that the issuers of preferred shares tend to be blue-chip companies like banks, insurance companies and utilities, preferred dividends are also pretty secure, since the big banks and other large companies would likely never cut their common dividends to zero. As an added bonus, preferred share dividends also qualify for the Canadian dividend tax credit.

For a taxable investor earning $70,000 a year, this means that a 7 per cent preferred dividend would net you about as much after taxes as you would get from a GIC that pays 8.6 per cent a year in interest – almost double the current GIC rates on offer from most of Canada’s big banks.

Of course, there are no free lunches in the investment world. Like every other investment, preferred shares come with their own set of risks. They are generally thinly traded. They tend to move around a lot as interest rates go up or down. And the number used to determine any OAS clawbacks on the income

earned from preferred shares is calculated from the grossed up dividend amount rather than the actual dividend amount.

But despite these potential drawbacks, preferred shares can still be a significant, meaningful – and perpetual – part of a solidly diversified portfolio, which will continue to contribute to your financial plan’s income objectives for many years to come.

This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.