Credit ratings help investors determine risk

Not all bonds are created equal.  More importantly, not all bonds are considered low risk.  Terms such as non-investment grade, high yield and junk bonds are often associated with higher risk bonds.

Government of Canada bond yields are the benchmark for bonds in Canada.  The yields are often quoted in the newspaper for the GOC 2, 5, 10 and 30 year maturity bonds.  Yields on GOC bonds are low because of the very high credit quality.  The Government of Canada has never defaulted on any of its debt obligations.  It is these bonds which other bonds such as Provincial issued and Corporate issued are compared.  Many people may be surprised to learn that the only province to ever default on a bond is Alberta.  This occurred in 1936.  However, bondholders did not lose their capital as the federal government provided the capital to pay out the bond holders on behalf of the province.

Rating agencies were created to help clients measure relative safety of different companies issuing bonds.  Three major rating agencies are Standard & Poors (S&P), Moodys and Dominion Bond Rating Services (DBRS).  These companies provide credit ratings on bonds (and certain other types of investments).

As an example, DBRS provides independent credit analysis on government debt, short-term corporate debt, preferred shares and long term corporate debt. DBRS assigns a letter grade that indicates the credit risk of the bond issue.

From DBRS, the following are the letter grades, credit rating and explanations:

  • AAA Highest Credit Quality: Highest credit protection, excellent financial health, very profitable future outlook, strong and stable industry and earnings (it is rare to achieve a AAA rating).
  • AA Superior Credit Quality: Very high credit protection, profitable future outlook, good financial health, strong and stable industry and earnings. Marginally below AAA.
  • A Satisfactory Credit Quality:  Good credit protection, medium to large company, fair to good financial health. Slightly cyclical.
  • BBB Adequate Credit Quality:  Adequate protection, fair future prospects, adequate financial health, more economically susceptible.
  • BB Speculative Credit Quality:  Uncertain protection, quite susceptible to changes in economic conditions, smaller size, less liquid.
  • B Highly Speculative Quality:  Highly uncertain protection, volatile earnings and highly susceptible to economic fluctuations.
  • CCC Very Highly Speculative:  Little or inadequate coverage, in danger of           Quality         default if situation not remedied.
  • CC Extremely Speculative:  Even higher danger of default than CCC rated quality bonds if situation not remedied.
  • C In Danger of Default:  In immediate danger of default. Lowest possible rating without actually being in default.
  • D Default:  Currently in default of principal and/or interest.

The above is one example of a company’s rating system.  The rating agencies each have a slightly different system.  Most use a three tiered nomenclature within each letter grade such as “low”, “mid”, or “high” to differentiate even further.   For example, an A High (AH) would indicate the highest rating within the single A grade, which would be one notch below a AA Low (AAL).

Rating changes for a corporation can have a significant impact.  Potential downgrades result in future financing efforts becoming more costly and difficult.  Pension plans, and certain managers may have guidelines as to the quality of fixed income investments they are permitted to hold.  The BBB rating and above is considered “investment grade.”  A downgrade beneath this level may result in some investors forced to sell these bonds.

Bonds with lower credit ratings are considered riskier investments and have a higher probability of default.

However, as an investor considering a lower credit quality bond you should be expecting a higher potential rate of return.  Investors must always balance the risk of default prior to maturity.

We encourage our clients to invest in fixed income that is considered investment grade (BBB) or better.   Here’s our three rules for minimizing risk when investing in fixed-income securities:

  • Focus on investment grade fixed income
  • Avoid structured products that can be costly and thinly traded
  • Diversify by purchasing different types, issuers and maturity dates.

Fixed Income 101: Carefully plan debt investments

Fixed income is an asset class that includes short term money market instruments, term deposits, GICs, government bonds, corporate bonds, debentures, and bond funds.  All of these investments are considered “debt” investments rather than “equity” investments.

When buying debt investments an investor is essentially lending money to the issuer of the bond.  For example, a company that needs to raise money generally has two ways to do so – issue stock in the open market or borrow.  By issuing a bond, the company is promising to repay money at maturity, along with, interest.

When purchasing fixed-income investments there are several things you should consider:  credit quality, liquidity, yield-to-maturity, term-to-maturity, and expected income stream of the investments.  The following five questions provide a framework to assist you in evaluating the relative merits of a particular investment.

1. What will my return be?

In order to determine how much you will earn on your fixed income investment, you generally need to consider two things: the coupon of the bond, and the overall yield.     The coupon is the percentage of the bond’s face value that you will receive as income on a periodic basis.  Most bonds pay coupons twice a year.  Yield (called yield to maturity for bonds) is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.

2. When will I get my money back?

Most fixed-income investments are issued for a specific period, such as five years, and have a set maturity date.  This is the date on which the face value or principal amount of your investment will be repaid by the issuer, or borrower.

3. How safe is my investment?

You should always check what type of security or guarantee is behind your investment.  Most bonds are not backed by specific assets, but are backed by the full faith of the issuing company.  An investment is considered to be extremely safe and have high credit quality when there is little likelihood that the issuing government or corporation will default on interest payments or not repay your principal.  Bond rating agencies provide investors with information to assist them in gauging the credit quality of their investments.  Lower quality companies will have a higher likelihood of not paying out and therefore be rated lower.  Lower quality bonds will offer a higher yield to attract investors.  Remember higher risk, usually means higher return.  Higher quality bonds, with little chance of default such as Government of Canada, have a lower yield.  You should choose a balance of risk and return that meets your tolerance level.

4. Why is the price changing on my bonds?

Before investing in bonds, you should be aware of any potential volatility that could affect the value.  GICs are an example of a type of fixed income investment that do not fluctuate in value.  However, regular bond prices are affected by moves in interest rates, and therefore prevailing yield in the marketplace.  Bonds prices move inversely to the prevailing interest rates.  As rates go up, bond prices come down and vice versa.  Generally, if a bond has a coupon that is larger than the prevailing yield in the market, the bond will trade above 100.00, considered a premium.  Conversely if the coupon the bond is lower than the prevailing yield in the market, the bond will trade below 100.00, considered a discount.

Bond prices are more likely to remain stable when they are high quality, more liquid and have a shorter term-to-maturity.  Changes in the price of bonds can present different opportunities for active investors.  However, if you plan to hold a bond investment until its maturity, you will receive its face value, therefore, market volatility will not be a factor (provided no default).

5. Can I sell my fixed income easily?

Although you may intend to hold a fixed income investment until maturity, you should still obtain an understanding of its liquidity.  Circumstances may change and you may require cash.  Some fixed income investments are extremely liquid which means that you can sell them easily before they mature.

If you sell a bond between periods of receiving coupon interest you will receive from the purchaser the accrued interest you have earned up to that date.  Less liquid bonds may be harder to sell in the secondary market.  GICs are different than bonds when it comes to selling.  Cashable GICs should not be redeemed within 30 days.

Early redemptions generally result in a loss of interest.   Cashable GICs are usually classified as cash equivalents rather than “fixed income” because of their liquidity and short duration (one year or less).  As for non cashable GICs, investors may be able to find a market to sell.  It is not advisable to buy GICs if you know you may need the money

Balanced investments show success

One of the first discussions we have with new clients relates to risk, which is often associated with equity investing.

Fixed income investments such as term deposits, guaranteed investment certificates and bonds are usually considered lower risk.

Most investors over the age of 40 should have a portion of their investments in fixed income as their time horizon is shorter.  However, the downside to having too much fixed income is the limited return potential in today’s market environment.  Cash and fixed income ensure capital preservation while the equity component provides increased growth potential.

The key to having “peace of mind” as an investor, is to have the appropriate balance that reflects your risk tolerance.  This balance is also known as your asset allocation.

Asset allocation classes include cash equivalents, fixed income, Canadian equities, US equities, International equities and real estate.  Let’s look at Jack Jones and the steps taken prior to choosing individuals investments.

Step 1 involves determining an asset allocation that best matches Jack’s risk and return expectations.  Here’s an example of his optimal asset allocation:

Cash Equivalents 5%

Fixed Income 30%

Equities – CDN 35%

Equities – US  10%

Equities – International 15%

Real Estate 5%

A person who is more conservative than Jack may want to increase the cash equivalents and fixed income component while decreasing equities.  What we find is that many do-it-yourself investors take an all or none approach to a specific asset class.  This means they may end up with either a 100 per cent equity portfolio or all of their money in GICs.   Portfolios that are 100 per cent invested in equities generally are more volatile, and hold greater risk of decline.  However, those who invest entirely in GICs may find it frustrating as yields are generally much lower.  In addition, for non-registered accounts interest income is fully taxable.  After tax is paid, it may be difficult for GIC investors to gain wealth after inflation is factored in.

Simply put, most investors should have a balanced portfolio that can weather different market cycles.

After the optimal percentages are determined above, Step 2 is to establish acceptable ranges as follows:

Cash Equivalents 0-10%

Fixed Income  25-35%

Equities – CDN 30-40%

Equities – US 5-15%

Equities – International 10-20%

Real Estate 0-10%

In a bull market cycle investors may find that the equity component of their investments may increase above the optimal amount noted above.  If the value of the equity class exceeds the acceptable range then a disciplined investment approach should involve rebalancing to the optimal percentages in Step 1.

This rebalancing is Step 3.  Selling equities and adding to fixed income and cash equivalents essentially shifts a portion of your profits to a lower risk asset class.

We encourage investors to stick to their long-term plan.  As fixed income securities mature, we should replace those investments with other fixed income options.

What happens in a bear market cycle?  Investors may find that the fixed income component as a percentage of their total investments increases as equity markets decline.  As noted above a disciplined approach to investing involves rebalancing.  It is possible that this process may involve allocating some of the proceeds from matured fixed income to purchasing equities.  This would only occur if equity markets have declined significantly.

Periodic rebalancing creates the discipline to sell a portion of your equity investments when times are good.  The cash equivalents and fixed income components should also be viewed as a potential source to purchase equity investments when the opportunity arises.

Borrowing to boost your RRSP

Some points to consider when using loans to augment savings

The maximum RRSP deduction limit has increased to $20,000 in 2008.  Those with an income of $111,111 or greater may qualify for this upper limit.  Members of a defined benefit pension plan will have to factor in any current and past pension adjustments.   Most people have salaries below this amount and often it is not easy to maximize annual contributions to an RRSP.

As the deadline for RRSP season approaches many investors may be asking if they should borrow to invest in their RRSP.  The answer really depends on your financial situation.  If you are contemplating borrowing to make an RRSP contribution we recommend you consider these following points:

Taxable Income

The greater an individual’s taxable income the more it makes senses to maximize RRSP contributions.  Reducing your tax liability is often a motivating factor for many individuals when making an RRSP contribution.  Those in the higher marginal income tax bracket should speak with their advisor.  Even if you do not have the cash on hand to make an RRSP contribution it may make sense to borrow the funds to make a contribution by February 29th.

Future Income

Individuals who are considered “employees” may receive a relatively stable monthly income that is predictable from year to year.  Business owners and entrepreneurs generally have fluctuating income resulting in a higher tax bracket one year and a lower tax bracket in another.  RRSP contributions may provide a unique way to smooth your taxable income.  Individuals may have one time spikes in income from selling a real estate investment or other type of investment that generates a significant capital gain.  Planning to utilize a portion of your RRSP contribution room to offset this future liability may make sense.

Term of the Loan

Interest rates are currently relatively low making borrowing for an RRSP fairly attractive.  Most financial institutions provide RRSP loans; however, the rates can vary considerably.  The better the terms of the loan the more attractive borrowing becomes.  Some individuals may choose to utilize their lines of credit, which may have favourable rates and the greater flexibility for repayment.  Business owners may want to utilize an RRSP loan rather than their lines of credit, which have been set up for emergencies.

Length of Loan

The general rule-of-thumb is that the quicker you pay back the RRSP loan the more advantageous it is.  Short-term loans of less than a year may have minimal interest costs and may assist those with fluctuating income.  The more difficult question is when do larger, longer-term loans make sense?  Long-term loans are often used to catch up on a significant amount of unused contribution room.  With longer-term loans it is even more important to weigh the other factors in this article.

Carry Forward Room

Prior to 1991, individuals lost their RRSP deduction room if they did not fully utilize it in a given year.  The good news is that unused RRSP contribution room may now be carried forward indefinitely and includes any unused RRSP deduction room accumulated after 1990.  The bad news is that if you wait too long then you’re missing the biggest benefit of an RRSP – the compounding growth that may occur on a tax deferred basis.  Regardless of the timing, we encourage most individuals to utilize their carry forward room prior to retirement.

Interest Costs

Interest on a loan for your RRSP is not tax deductible. However, money borrowed to earn non-registered investment income may be deductible. This is why it may make sense to use extra cash to contribute to your RRSP and borrowed funds for non-registered investments.  If you have non-registered investments and are considering an RRSP loan you should meet with your accountant first.  There may be a way you can arrange your finances to ensure that more interest costs are deductible.

Return on Investment

This is perhaps the most difficult component for people to analyze.  If you knew with certainty the investment returns you would obtain then the decision may be easier.  Let’s step back and disregard how your investments may perform in the near term.  An RRSP is normally established with a long-term time horizon.  The focus should be on picking the highest quality investments that will prevail in the long run, regardless of market volatility.  We understand that many people scramble to make a last minute contribution to their RRSP.  This is okay provided care is taken when making the investment decision.  If the energy is focused on picking the best investments and the best advisor, then an RRSP loan may make sense.

Simple Strategy

Last year we highlighted a simple strategy that investors could adopt to ease the cash flow burden of trying to come up with their RRSP contribution limit every tax season.  Let’s consider an investor with a $20,000 RRSP contribution limit for the upcoming year.  For this investor we recommend multiplying their RRSP deduction limit by 75 per cent and dividing by 12 to obtain the monthly pre-authorized contribution amount of $1,250.  In either January or February of the following year, the investor could utilize their line of credit or obtain a short term RRSP loan to contribute another $5,000 to top up to the maximum.  After filing the tax return, the combined RRSP contributions of $20,000 may provide enough of a tax refund to pay off the short-term loan or line of credit.  This of course assumes that sufficient tax was withheld on other sources of income throughout the year.

The above strategy is a combination of “automatic” savings by paying yourself monthly and a “forced” short-term loan strategy that creates the discipline to pay off the loan as soon as possible.  This combination has worked well for many successful investors.

RRSP deduction limit has value

Registered Retirement Savings Plans have been around since 1957, allowing investors to sav for their retirement while providing a shelter on tax.

One of the most significant legislation overhauls to RRSP legislation was in 1991 with the carry forward provision.  Now investors no longer have to make a “use it or lose it” decision.

The provision allowed unused RRSP contribution limits after 1990 to be carried forward.  The RRSP deduction limit is included on your Notice of Assessment that Canada Renue Agency sends after you file an income tax return.

Your RRSP deduction limit may be carried forward indefinitely.  This is an important component for everyone to note, considering most people have incomes that increase over time.

Consider Mr. Samson, who is 25 years old and has been a professional student for much of his life.  He decided in 2006 to start working and earned $40,000.  In 2007, Mr. Samson’s RRSP deduction limit is $7,200 ($40,000 x 18 per cent).  Mr. Samson feels that he will be making a larger salary soon and would rather dedicate his current year earnings to paying off his student loans.  He does not lose the $7,200 RRSP deduction limit.  Every year that he does not contribute to an RRSP he will be accumulating a greater deduction limit to be used in the future.  If his income increases then he may save more in taxes by delaying his RRSP contribution.

Marketing by financial institutions may be one reason people rush out and make last minute contributions.  It may also be recent news question whether Canada Pension Plan and Old Age Security will exist when they retire.  Or perhaps it is some internal fear of having enough to live on at retirement that pressures so many into making RRSP mistakes.

Check your Notice of Assessment and your deduction limit before you make any contributions.  You should understand what each line represents.  If you are a member of a defined benefit plan then your statement will have pension adjustments.  If you are a member of a defined contribution plan you should factor in contributions made through work.

The sum of both of these contributions should be factored in prior to making any additional RRSP contributions.  Care should be taken to ensure that you do not contribute over your deduction limit.  Canada Revenue Agency provides a buffer of $2,000 before an excess contribution is subject to tax.

Here’s another illustration to make the point:

For nearly 20 years Mr. Phillip has focused his after tax savings to paying down his mortgage.  At 50, he is proud that he is mortgage free.  Mr. Phillip has managed to accumulate approximately $97,200 of RRSP deduction limit.  Now that he is mortgage free he would like to accelerate his retirement savings but does not know where to begin.  Mr. Phillips annual income is $85,000 and he has been dedicating approximately $1,500 a month towards mortgage payments.  Annually Mr. Phillip’s RRSP contribution room is increasing by approximately $15,300 (18 per cent x $85,000).   We discussed with Mr. Phillips that since he no longer has to make monthly mortgage payments, he should consider making monthly pre-authorized contributions to his RRSP.   We mapped out a plan that he could contribute $1,950 monthly to his RRSP, claim the amount as a deduction and save taxes.  The net amount would likely be close to his previous monthly mortgage payment of $1,500.  Best of all, by age 61, Mr. Phillip should have caught up and fully utilized his RRSP deduction limit.

Contribute Early

Time has an amazing way of compounding investment returns.  Investors who begin contributing early to their RRSP are more likely to be financially prepared for their retirement years.  The sooner people begin investing; the longer the savings will be able to grow on a tax sheltered basis.  Tax deferred compounding over a larger number of years should naturally result in a greater accumulation of funds.  One benefit to waiting later in the year to contribute is the greater certainty you will have regarding your income levels and your actual deduction limit.

Avoid Mistakes

If a person pulls funds out of an RRSP, they do not recover the deduction limit.  This amount is lost.  Clearly understanding that your RRSP deduction limit will not vanish if not used should ease some financial pressures.

An RRSP should generally be set up to fund your retirement and involves a long-term discipline.  If you feel that you will likely have to make a withdrawal then you should consider waiting until you are confident that the funds are committed until retirement.  We would rather see someone miss out on a little bit of time to ensure they are not making the mistakes that some people make.


How to benefit from a declining US dollar

Is the strength in the Canadian dollar good news for your investments?  It really depends on where you are currently invested.  If you’re primarily within Canada you may have felt little impact from our dollar rising to parity with the greenback.

Canadian investors most affected are those who have greenback-denominated investments as U.S. investments are negatively impacted when the U.S. dollar deteriorates.

We pay our bills in Canadian dollars and must calculate investment returns in the same way.  People with investments in the United States or other foreign securities should track the foreign exchange rate on the date of each purchase and sell.  Upon selling a position you will need to report the capital gain or loss in Canadian dollars on your tax return for taxable accounts.

Share Illustration

Four years ago an investor purchased 200 shares of General Electric (GE) at $30 US when the exchange rate was 1.00 USD to $1.40 CDN.  The adjusted cost base of the purchase in GE is $8,400 CDN ($30 x 200 x 1.40).

Let’s assume that GE is trading today at $41 USD and the CDN exchange rate is equal to the U.S.dollar.  At first glance the investor looking at their investment statement may feel they have a capital gain, after all the stock has increased from $30 to $41.  If the investor were to sell these shares today, the proceeds for Canadian tax purposes would be $8,200 CDN ($41 x 200 x 1.00).  The investor would realize a capital loss of $200 CDN even though the share price had increased by approximately 36 per cent.  The exchange rate difference resulted in a capital loss.

Currency exposure should play an important component of any investment decision including bonds, money markets, bank accounts, etc.  Prior to the end of the 2007 taxation year we encourage you to review your foreign denominated holdings.  To analyse the currency impact, you will need to determine the date you purchased your investment along with the exchange at that time.  This will assist you in estimating the adjusted cost base in Canadian dollars.  If you are unsure of the foreign exchange rate on a given day you may look it up on a foreign currency website such as  The next step is to look at these same holdings and calculate the current market value in Canadian dollars.  You may be surprised by the outcome of this exercise!

For the last couple of years many economists have been forecasting that the Canadian dollar would get stronger relative to the U.S. dollar.  Many investors avoided investing in U.S. denominated securities for this reason.  Now that we are at parity, what should investors be considering?  When seeking out U.S. denominated investments the following tips should be considered:

Tip 1 – Settlement

Investors with registered (RRSP, RRIF) and non-registered (cash, margin) accounts should consider the most advantageous place to hold foreign denominated securities.  If you have the option, we recommend holding foreign denominated securities within non-registered accounts.

Transactions within registered accounts settle in Canadian dollars.  Non-registered accounts can hold foreign currencies and also settle those transactions in that currency.  This applies to the initial purchases, income payments, and sells.

Tip 2 – Currency Spread

Every time one currency is converted to another there is a cost to the investor.  Some places may charge a service fee or transaction cost.  The biggest cost is the difference between the price that investors buy at (the bid) versus the price that investors sell for (the ask).  This is commonly referred to as the spread.  If your investment is held in a non-registered account you should consider maintaining a U.S. component.  You may ask your financial advisor to settle the transaction in U.S. dollars.  Proceeds from the sell of one U.S. denominated company may be used to purchase another U.S. investment without conversion costs.  Interest and/or dividends from U.S. investments may also be paid in U.S. dollars.

Tip 3 – Taxation

Certain foreign income is subject to a withholding tax and may be an absolute cost to you if the underlying investment is held in a registered account.  If the foreign investment is held in a non-registered account then Canadian residents may be able to claim a foreign tax credit for the amount withheld on their income tax return.

Tip 4 – Sectors

Many investors may feel that investing in the U.S. provides diversification by geography and currency.  Another great reason to consider foreign investments is to obtain exposure to different sectors.  Canada is very strong in the resource and financials sectors.  Countries such as the U.S. often play a part of a diversified portfolio in sectors such as consumer goods, technology and health care.

Tip 5 – Defensive Stocks

The term defensive stock is used for those companies whose financial results are not highly correlated with the larger economic cycle and will generally have better performance during recessionary periods.  Defensive sectors include utilities and consumer staples such as food, beverages, prescription drugs and household products.  Fear of a U.S. slow down or recession may be one reason why some investors may want to focus on Canadian domiciled investments or those outside of North America.  Some of the best defensive names are in the U.S.  Many of those same companies have significant international operations which may safeguard against a domestic slowdown.

Tip 5 – Time Horizon

Some economists are forecasting further strength in the Canadian dollar relative to the U.S. dollar.  Unfortunately no one knows for certain which way currencies will move.  Several variables impact the direction of currencies and may result in further weakness in the US dollar in the short term.

Investors with a longer-term time horizon and the risk tolerance to withstand currency fluctuations should look at all possible outcomes, this includes a U.S. dollar that begins to appreciate during your time horizon.

The argument for diversification and holding U.S. dollar investments makes even more sense when our dollar is strong and U.S. investments are cheaper.  Movements in a foreign currency may have a greater impact on returns than the movement in the stock price.


Split shares separate income and growth

Some investors require growth from their investments.  Others want income.   At times an investment in common shares may offer both income and growth potential.  A structure referred to as a “split share” attempts to separate these two components.

A split share is a structure that has been created to “split” the investment characteristics of an underlying portfolio of common shares into separate components.   This division may be done to satisfy the different objectives of investors.  Typically, these structures consist of a preferred share and a capital share that trade separately in the market.  Together these two securities are known as a split share.

The description may be confusing to some investors, especially since the preferred shares and capital shares trade independently.  A key component to understand is that you do not have to own both components.  Investors generally own either the “preferred” component or the “capital” component (some investors may own both). Conservative investors requiring income may find the preferred component more appealing.  Growth oriented investors may find the capital component more attractive.

In a typical split share issue, the preferred share receives all the dividends from an underlying portfolio of common shares and is entitled to the capital appreciation on the portfolio up to a certain value.  The capital share receives all the capital appreciation on the portfolio above what the preferred share is entitled to but receives no dividends.  The capital component is generally considered riskier than the preferred component.

The following is an illustration of how a split share is created and how the returns are divided between preferred and capital shares.  As an example, a split share may be created by an investment firm by using existing common shares of publicly traded companies.  Let’s use a fictional company called XYZ Bank.

We will assume that XYZ Bank’s common shares are trading on the TSX at a market price of $50.00 per share and pay an annual dividend of $1.50 (or three per cent dividend yield).  To create a split share based on XYZ Bank, an investment firm purchases XYZ Bank in the market and places them in an investment trust called XYZ Split Corp.

The trust then issues one XYZ Split Corp preferred share at a price of $25.00 for each XYZ Bank common share held in trust.  The preferred share receives the entire $1.50 dividend from the XYZ Bank common share.  This produces a dividend yield that is double that of the common share (six per cent versus three per cent) because half as much money receives the full common share dividend ($25 versus $50).  In exchange for the higher yield, the preferred share is only entitled to the first $25 of the value of XYZ Bank’s common shares that lie within XYZ Split Corp.

XYZ Split Corp also issues one capital share for each common share held in the trust.  The capital share is priced at $25 and is entitled to all the capital appreciation in the underlying shares of XYZ Bank above $25 per share for the term of the XYZ Split Corp.  As this illustration demonstrates, the two split share components are:  One XYZ Split preferred share plus one XYZ Split capital share equals one XYZ Bank common share.

There are many types of split shares as well as underlying investments.  One fact that most split shares have in common is the leverage effect.  Generally, at inception a split capital share offers approximately two times the leverage.  Unfortunately, this leverage also impacts investors in a down market.  For example, a 25 per cent decrease in the underlying investment XYZ Bank may translate into a 50 per cent decline in the XYZ Split capital share value.  A split share structure, especially the capital share component, should only be considered if an investor desires leverage.  Do you use leverage in other components of your account?  What is the position size relative to other investments in your account?  What is your time horizon versus the term to maturity of the investment?  This last question is important, as investors often require patience for leverage strategies to work in their favour.

Split shares are originally offered through a new issue.   After the new issue, both the preferred and capital shares trade in the market generally at a discount to their net asset value (i.e. the underlying common share).   Investors interested in split shares would generally prefer shares that trade at a discount as opposed to those that are trading at a premium.

Although the underlying investment(s) may have many shares exchanging hands each day, a split share may have very little trading activity.  As a result the market for split shares is generally very illiquid making the purchase or sale of split shares difficult at times particularly with larger orders.

In recent years, many financial institutions have not issued “hard retractable” preferred shares, meaning that they have a set maturity date.  Instead, perpetual preferred shares have been issued in their place, with no maturity date.  Perpetual preferred shares are interest rate sensitive.  As rates rise the underlying value of a perpetual may decline (and vice versa).  A positive component to the preferred side of a split share offering is that the structure generally has a set term resembling maturity characteristics of a “hard retractable”.  Terms for most split shares are generally five to seven years.

As with any structured product, fees are associated to set up the structure, compensate the investment firms and other ongoing costs.   Investors looking at the capital component of a split share should be asking, “why not purchase the underlying investment directly?”

As with any investment, the main decision to purchase a split share should be based on the outlook for the underlying company over the term of the structure.  Some split shares may be based on a basket of securities in one sector, index, etc.  In these cases an investor should have a positive fundamental outlook for the underlying security and its sector.

Closed-end funds grow popular

Funds allow investors the ability to obtain diversification by pooling their dollars together.  Investors must be careful to pick the fund managers they feel will do the best job.  With the number of funds steadily increasing this is not an easy task.  In addition, there are a variety of different funds available with different investment objectives, strategies, and portfolios.

The purpose of this column is to discuss investment strategies with respect to “closed-end” funds.  It is important for investors interested in funds to obtain an understanding of the difference between “closed-end” and “open-end” funds.

Open-End Funds

Most of the funds on the market place are open-end funds (OEF), which generally have no restrictions on the amount of shares the fund will issue (unless a fund manager closes the fund to new purchases). The fund will continuously issue shares and also buy back shares when investors wish to sell.  OEFs are issued by an investment company, and are subject to certain disclosure rules.  After purchasing an OEF you will generally receive a full prospectus in the mail outlining the funds investment objectives, strategies and fees.

Closed-End Funds

Growing rapidly in the market place are closed-end funds (CEF).  The initial public offering is generally done through a prospectus, similar to OEF.  This document is intended to provide investors complete information on the structure as well as all applicable fees.  We encourage investors to read this document.  As an example, the prospectus may specifically state whether the CEF may use leverage within the structure.

Important Difference

CEFs do not continuously offer their units for sale as an OEF would.  CEFs sell a fixed number of units at one time, through the initial offering.  After the initial offering the shares typically trade on a secondary market, such as the Toronto Stock Exchange (TSX).  CEFs trade on an exchange much the same way as individual equities.

Net Asset Value

OEFs are bought and sold at net asset value (NAV) directly from the fund company.  NAV is the total value of the fund’s portfolio less liabilities generally calculated on a daily basis.  As noted above CEFs trade on an exchange after the initial public offering.  As a result, they are generally bought or sold at a discount or premium to its NAV.  Although a fund company does not redeem CEF units, most disclose their NAV daily.


When CEFs disclose their NAV, these may be compared to the most recent trades in the secondary market.  Investors who look at the various CEFs offered in the secondary market may find that most trade at a discount to their NAV.  It is not uncommon to see some CEFs trading at a discount of 5 to 10 per cent or more during market volatility.  This may be a little frustrating for investors who purchased a CEF at the initial issue and are now looking at selling their units.  On the flip side, opportunities may become available for investors looking on the exchange for deep discounts (large differences between NAV and market value).


Some CEF investments are not redeemable for a period of time.  CEFs are generally structured so they are not required to buy units back from investors until maturity of the structure.  CEFs therefore may not be suitable for individuals who desire liquid investments.  CEFs are generally not redeemable by the company (see redemption privileges below).   Investors should use caution prior to selling CEFs on the secondary market.  Many CEFs have very little trading volume and care should be taken before entering “market” orders.  Prior to making a CEF purchase on the secondary market, investors may be able to look at the historical volumes and total issue size of the CEF.  This may provide some indication as to the future liquidity.


As noted above, the trading volumes on CEFs may be very low.  In some cases the spread between the bid and the ask may be significant.   Once a secondary market exists for a CEF, investors are able to sell their units if there are buyers.  It is not uncommon to see a significant change in the market price of a CEF when an investor sells a large position.

Redemption Privilege

One feature that investors should consider prior to purchasing a CEF is if the offering document provides for a redemption privilege.  Some of the original CEFs do not have a redemption privilege.  We would expect some of these CEFs to possibly trade at a greater discount than those that have redemption privileges.  Most of the newer CEFs provide some form of redemption privilege.  The more frequent the redemption privilege the more flexible for the investors.  Some offering documents provide redemption privileges equal to 100 per cent of NAV.  Other less attractive CEFs may have redemption privileges equal to 90 or 95 per cent of NAV.  Individuals who have closed end funds should be aware of these redemption dates, if applicable.  The offering document generally provides full details with respect to redemption privileges.

Ongoing Management

Companies may establish a CEF (rather than an OEF) for the ease of administration.  After the initial offering, management knows the amount of funds available for investment purposes.  Administratively they do not have to be concerned about additional purchases or early redemptions.  Redemption rights by investors generally must be provided to the issuer well in advance and settlement may be longer than the normal three days.

Income Payments

CEFs may be structured in a manner that provides a regular stream of income to investors.  Some structures are more beneficial in a non-registered account if the income payments are tax efficient.

Typical CEFs

The following are the main categories of CEFs:  global equity, income and growth funds, fixed income funds, preferred share funds, income trust funds, commodity funds, infrastructure funds, and alternative asset management funds.

We encourage all investors considering a closed end fund to understand the limitations and risks.

Informed decisions are necessary in the world of structured products

Investment bankers and financial institutions have become very creative in the structured products they design.

Essentially, these products are designed to meet investor demand.  Special features are often added that may relate to risk and return, such as principal protection, while some are arranged to distribute tax efficient income.

Nearly all of them have a targeted investment objective.

Structured products are generally a pre-packaged investment strategy that may include a combination of investments and derivatives.  The structure is generally linked to the performance of an underlying security or basket of securities.  The structure is generally linked to the performance of an underlying security or basket of securities.

Every structure is different and some may hold domestic investments while others are linked to foreign investments.  Some structures may be linked to direct holdings, other funds and indices.  Often, the linked investments may be combined with derivatives making structures more complicated to understand.  Typical types of derivatives include options, forwards, and swaps.

Rather than explain the mechanics of derivatives we will explain the main reason why they exist.  Derivatives exist to enable the transfer of risk from those who do not want to bear the risk to those who do.  In other words, some investors may use derivatives to reduce risk (for a fee), while others may use them to increase risk and the potential for return.

So, how are they used?  Structured products are generally an alternative to a direct investment.  When people get excited about an asset class or a specific type of investment then financial companies are likely to respond by creating a structured product to meet the investment demand.  Structured products may be added to a portfolio for a number of reasons, to provide diversification, exposure to different asset classes and geographies.  Investors may find them appealing because they provide lower correlation to other investments within a portfolio.  Simply put, they react and perform differently to various market conditions.  The products that offer some form of protection may provide a method of managing downside risk.  As noted above, many structured products provide tax-efficient income.

During the technology boom of the late 1990’s many people were following financial news and seeing incredible gains in this sector.  Sophisticated and unsophisticated investors wanted to buy technology.  Financial firms responded by setting up technology mutual funds and other structures linked to technology.

Many investors want to preserve their capital, but even more so after the tech bubble and 9/11.  Around this same time, fixed income investments, such as bonds, were barely staying ahead of inflation and taxes.   Financial firms responded quickly by offering financial products with equity exposure and principal protection.

Trust Example

Prior to the federal government’s “tax fairness plan” announcement on October 31st, many investors were excited about income trusts.  Several structured products were created to hold a basket of income trusts and provided investors an easy way to obtain diversification within this type of equity investment.

Retirement Example

Some companies have developed income and segregated funds that are more complicated than previous series.  Some of these funds are focused on creating retirement income and have different features that individuals should fully understand prior to making an investment.

Infrastructure Example

Some structured products are very interesting to read about.  Take the recent “infrastructure funds” as an example.  The average investor cannot simply go out and buy a road or bridge.  Some of these structures allow individual investors access to these types of asset classes that have primarily been reserved for private equity and pension plans.

Other Examples

New structures are continually being created.  Many of these structures may provide investors access to international investments.  Other funds may have specific objectives including uranium funds, water funds, socially responsible investing, etc.  A key point to remember is that with some types of investments or asset classes, structured products may be the easiest way to gain access.

Who uses Structured Products?

Although heavily marketed to the retail investor, they extend to all individuals regardless of net worth.  Investors with small accounts may be attracted to the low minimum amounts required for most structured products.  Hedge funds are generally targeted to the high net worth individual.

Understand the Structure

Regardless of the amount people would like to invest, or their level of sophistication, it is important to understand the structure before making a purchase.  This understanding should include how the investment objectives of the structure fit into your overall plan.  Take a detailed look at the risks and rewards, fees, and liquidity.  Comparing structures issued by different companies may soon reveal the different options available.  A complete understanding of the investment is also necessary to monitor the ongoing performance.

We caution all investors to only consider purchasing structures they understand and are suitable for their plan.  We recommend avoiding investments you do not understand.  From time to time you may miss out on a good opportunity, however, successful investing also involves avoiding poor investment decisions.

When the dust settles on income trusts

Although a few weeks have passed since the news effecting the taxation of income trusts, time isn’t helping investors forget the Oct. 31 announcement.

The spectrum of comments in the media has ranged from general acceptance to outrage.  Two things are certain-  investors dislike negative surprises and the federal government is not going to reverse this announcement.

Investors who overweighted income trusts for a long period of time have profited handsomely.  One could surmise that it was good while it lasted.  The best way to combat volatility and uncertainty in the market is to diversify your portfolio.

The first step in diversifying your portfolio is to establish an Investment Policy Statement (IPS).  An IPS provides the framework for developing a disciplined investment approach.  A disciplined investment approach nearly always prevails in the long run.  Every individual has to obtain an understanding of the level of risk they are comfortable with.

An IPS also highlights the need to rebalance individual positions and asset classes periodically.  Determining an appropriate asset mix between cash, fixed income and equities is the most important decision investors need to make and a critical component of an IPS.   Any change in your personal situation or the taxation of investments should result in individuals reviewing their current IPS.

Illustration:  Mr. Patterson has the following asset mix – 5 per cent cash equivalents, 30 per cent fixed income and 65 per cent equities.  The cash equivalents component is invested in a money market fund.  Fixed income is comprised of Guaranteed Investment Certificates (GICs), bonds and treasury bills.  Mr. Patterson’s 65 per cent equity component is invested as follows:  common shares (25 per cent), preferred shares (10 per cent), mutual funds (10 per cent), exchange trade funds (10 per cent), and income trusts (10 per cent).  In the first week following the October 31 announcement, the income trust sector index declined on average approximately 14 per cent.  Some of Mr. Patterson’s exposure was to real estate income trusts which were not impacted.  There is no doubt that Mr. Patterson’s portfolio was negatively impacted from the income trust news.  Fortunately, other components of his investments, primarily his common shares, performed positively during this same period and his combined portfolio actually increased in value.

Concentration and Timing

Mr. Patterson’s portfolio mix described above provides one example of a diversified portfolio.  In many cases a diversified portfolio really shines when negative market events occur.  Individuals that chose to concentrate or overweight a portion of their portfolio within income trusts have been impacted the most, as were those people who purchased income trusts recently.  We encourage investors to understand the asset class weightings in their portfolio.  What component of your portfolio is comprised of income trusts?   Once determined, this should be compared to your overall investment plan.

Structured Products

As the income trust market has grown in popularity so too has structured products that pool these types of investments.  Many of these pooled products are structured as “closed end funds.” They trade on an exchange and may not be readily redeemable from the fund company.  As these structures trade on an exchange they may trade at a discount or premium to the actual Net Asset Value (NAV) of the underlying investments.  Some closed end funds have very low trading volumes and in the absence of individuals wanting to purchase, individuals entering market sell orders may receive a discounted value.   These structures often provide investors the ability to redeem at NAV at predetermined times.  We encourage investors to obtain an understanding of these dates and the various redemption privileges.

Active versus Passive

Individuals who have purchased structured products may want to determine whether the fund is actively managed or whether it has a passive structure.  Fees for actively managed funds are generally a little higher than passive structures.  Examples of a passive structure may be a basket of 100 of the largest income trusts, equally weighted.  Certain actively managed structures may provide a flexible mandate to change to other income asset class types, while others may be restricted to income funds only.  Investors should determine whether their funds hold income trusts and whether the mandate is flexible or not.  Investors holding active and passive income trust structures should assess these strategies in light of the recent news.

All Or None

For those investors that are holding individual income trusts the options are a little different.  The recent news highlights the need to hold quality investments.  Investors should clearly understand that the recent announcement does not wipe out the fact that many of these trusts are solid businesses that will continue to pay a stream of consistent income.  The tax efficiency will continue until 2011.  Often at times investors feel they have to make an all or none decision.  If you are undecided as to the best course of action then sometimes the middle road is the best option.  Selling half of a position that you are uncertain about will reduce your overall exposure but still provide you some income and hopefully the benefits if the trust market stabilizes or improves from its current state.

Stop Loss Orders

When uncertainty still exists regarding a specific investment many investors choose to put a stop-loss order to minimize further downside risk.  This type of order is used not only to reduce further losses but also to protect unrealized gains. This type of order is automatically triggered once the security’s price declines to the stated limit within the determined time and becomes a market sell order.  Investors should be cautious when entering stop orders on thinly traded positions.

Tax Consequences

Individuals that hold income trusts within a taxable account should assess their current tax situation.  Most individuals that have held these investments for a significant time may still have significant unrealized capital gains.  Selling prior to year-end may realize these gains and create a taxable capital gain.  Others that have recently purchased income trusts may have unrealized capital losses.  Tax loss selling is a strategy that can be used to offset capital gains from other investments.

What type of investment would you purchase today?  Some individuals may see value in those income trusts that have declined in value.  Others may choose preferred or common shares.  Solid research on blue chip equities has been a long-standing successful approach to equity investing.

Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors.