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Timely advice — lend money to a deserving company

Fixed-income securities like preferred shares are solid investments, says Investor’s Digest of Canada, but shop carefully for the best buys.

It’s simple economics. A business has two basic needs, labour and capital.

We can easily see how labour functions. But it’s not always obvious how capital works for a business (and has it ever been more obscure than in the derivatives-crazed financial system of recent years?)

Still, we can take a hand in bringing capital to business. In addition to owning common shares, we can lend money and collect interest.

And in today’s marketplace, that is exactly what we should do, says Dr. Sunil Vidyarthi. Writing in Investor's Digest of Canada, he assures us that our loans — in the form of bonds and preferred shares — are the most desirable investments today.

Why not dividends, you may ask? “The thinking goes like this,” says this analyst, who is president of Value Sciences. “Companies under stressful circumstances may reduce or eliminate dividends, but fixed-income holders must get paid.”

The analyst begins his case with a look at perhaps the most notable bondholder case in Canadian history.

The last one to suffer

The first time the BCE Inc. (TSX-BCE) deal stumbled, it was a bondholders’ suit that lay in its path. The bondholders claimed the deal lowered the value of their holdings. While they lost in the Supreme Court, “they still had a little clause dealing with solvency,” says Dr. Vidyarthi.

“In hindsight,” he adds, “what accounting firm would grant a positive solvency opinion on the biggest ever debt-financed deal in the midst of one of the worst economic times?” In the end, of course, the accountants refused to issue such an opinion, and the deal died.

“In other words, fixed-income holders have real power, and you will be the last one to suffer if the worst does happen to your borrower.”

Still, you really can’t be too careful these days, says the analyst, so make sure you know what you are buying. While a fixed-income investment may be your best bet, some are better than others.

More fixed than others

There are newly issued preferred shares with step-up clauses (in which the company can essentially alter the contract under certain conditions) and apparently high-yielding capital shares from apparently solid banks.

But some forms of income are more fixed than others. Preferred shares fall somewhere between a bond and a stock, Dr. Vidyarthi points out. Where they fall depends on the covenants or clauses in the contract.

As more people turn to these securities for security, new issues keep coming onto the market. But the prospectuses are filled with the same old legalese, observes the analyst, and lots of it. You, or someone you trust, will have to go over it carefully.

Essentially, preferred shares are based on the corporate-bond rate. And that rate has separated from the government bond rate, which is notoriously low at the moment.

The rate ranges from five to nine per cent, depending on the rating the issuing company holds. The higher corporate bond yield, the higher the yield on preferred shares. Hold on to them forever, and you keep on getting the yield.

“That’s still a lot better than a common stock yielding six per cent or even higher, because a company can change its mind about dividends,” insists the analyst. “That hasn’t happened among Canadian banks for a long time, but neither have large financial companies like AIG and Lehman Brothers gone under for a long time.”

Your preferred yield will usually be the last thing to be cut. The banks need that money to get cash into their vaults.

Not for trading

There is one conundrum with preferred shares. If you bought a preferred series that promised a 5.4 per cent yield last fall, the value of your shares may have fallen now that newer issues of preferred shares are yielding more than 7 per cent.

So if you are in a hurry to sell these shares for any reason, Dr. Vidyarthi says, you will have to accept less than you paid in the first place. “In other words, these are long-term investment vehicles, not for trading but for retirement portfolios.”

This has created a quandary for the banks, which need the money they get from preferred shares, but face resistance from investors worried their assets will lose value quickly.

The analyst illustrates with a look at a recent issue from National Bank (TSX-NA.PR.P). Known by the cumbersome name of non-cumulative five-year reset first preferred series 26, it offers a 6.6 per cent yield, with a step-up clause calling for a yield of 4.79 per cent plus the yield of the government of Canada five year-bond after five years.

This assumes that government bonds are unlikely to yield more than they do now, some two per cent. The bank gets its money and you get the assurance of a 6.6 per cent yield for the next five years or more.

And if the government bond yield goes up to 4 per cent, your yield soars to 8.5 per cent (government five-year yield plus 4.79 step-up), right? Uh, not necessarily. Another clause in the prospectus allows the bank to buy the shares back for what you paid.

Still, this preferred series is a solid investment trading near its issue price of $25, says Dr. Vidyarthi. He tells his Investor's Digest of Canada readers “if you can get six per cent to seven per cent dividend, instead of tax-unfriendly interest income for the next five years and get your money back, it is worth jumping in.”

So in this case, safety comes with a careful reading of the fine print. Which is just fine as far as this analyst is concerned. Now more than ever, it is absolutely essential for investors to know exactly what they are buying.