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.