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A Royal Bank of Canada sign in downtown Toronto. (MARK BLINCH/REUTERS)
A Royal Bank of Canada sign in downtown Toronto. (MARK BLINCH/REUTERS)

INVESTOR CLINIC

Beware the tax trap of these tempting preferreds Add to ...

I have recently been considering rate-reset preferred shares of the big banks. Many of the series issued in 2009 will mature in 2014 (for example, RY.PR.T, CM.PR.L, TD.PR.E). While the yields look pretty good now, is there a general consensus regarding what will happen to the shares and the yields at five-year maturity?

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Preferred shares can be complex instruments, and rate-reset preferreds have some extra wrinkles that you need to understand. Otherwise, you could be in for an unpleasant surprise.

First, some background. During the credit crisis of 2008-09, banks issued rate-resets – also known as fixed-resets– to raise capital. With yields typically ranging from 6 to 6.5 per cent, the shares proved hugely popular with investors who snapped up billions of dollars worth of the newfangled securities.

What made the shares especially attractive was the built-in protection from rising interest rates. Specifically, at the end of five years – and every five years thereafter – the fixed dividend would reset at a predetermined spread over the five-year Government of Canada bond yield. The spread was quite generous, often in excess of four percentage points.

Alternatively, holders were given the option to convert to a floating dividend based on an identical spread over the yield on three-month Treasury bills.

But here’s the catch – and it’s a big one: The banks gave themselves the option to redeem the shares on the reset date. With preferred yield spreads having contracted sharply now that the financial system has stabilized, “virtually all of them are going to be called,” says preferred share expert James Hymas, president of Hymas Investment Management. Any high-quality preferred with a spread of at least three percentage points is pretty much a lock for redemption, barring another financial crisis, he says.

Because the banks can raise money at much lower rates today, there is no reason to continue offering such fat yields.

This has major implications for investors considering rate-reset preferreds that were issued in 2008-09. Take the example of RY.PR.T. According to Globeinvestor.com, the yield on this Royal Bank of Canada preferred is about 6 per cent, calculated as the annual dividend of $1.5625 divided by the current share price of $26.25.

Sounds pretty good, right? But this “current yield” is misleading. Because RBC has the right to call the shares at their par value of $25 on the reset date of Aug. 24, an investor who buys at the current price will very likely suffer a capital loss that will offset part of that juicy current yield.

“Most investors look only at current yield,” Mr. Hymas says. But the more important number is the “yield-to-call” (similar to the yield-to-maturity of a bond), which also takes into account the expected capital loss or gain. In the case of RY.PR.T, the yield-to-call is about 2.3 per cent.

There are tax implications, too. If you’re investing in a non-registered account and buy a rate-reset preferred with a current yield of 6 per cent, you’ll have to pay tax on the inflated dividend. Even taking into account the dividend tax credit and assuming you can use the capital loss to offset other capital gains, you could end up paying an effective tax rate of more than 30 per cent on the yield-to-call of 2.3 per cent, Mr. Hymas says.

Worse, if you can’t use the loss to offset capital gains, your effective tax rate could climb to 80 per cent or more if you’re in the highest income bracket. To avoid the tax hit, you could hold the shares in a registered account.

Despite their drawbacks, bank rate-reset preferreds can serve a useful purpose, he says. Because of the high probability that shares with hefty spreads will be called, some investors use them as a low-risk cash reserve. Earning 2.3 per cent may not be as good as 6 per cent, but it’s still better than the yield on money market funds or guaranteed investment certificates.

“Before you even think about buying them, you have to do your calculations properly and account for taxes, if any,” Mr. Hymas says.

For more on preferred share yields, plus a link to an online yield calculator, read Mr. Hymas’ article at goo.gl/tjr72.

Follow on Twitter: @johnheinzl

 
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