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Investor Clinic

Why preferreds are falling but corporate bonds aren't Add to ...

You've got questions. And we've got answers.

In a departure from Investor Clinic's usual format, in which we delve into a single scintillating investment topic, today we'll be answering some of your questions.

We'll be doing this from time to time, so keep those investing questions coming. Every month or so we'll feature a handful of them here. If we don't know the answer, we'll find someone who does.

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Let's start with an easy one.

Are dividends received inside a registered retirement savings plan taxed as income for that year?

No they are not. Dividends, interest and capital gains from investments inside an RRSP are not taxable. When funds are withdrawn from an RRSP at a future date, however, the amount is added to your taxable income for that year.

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Generally, experts recommend holding dividend stocks outside an RRSP to take advantage of the dividend tax credit, while keeping interest-paying securities - which receive no preferential tax treatment - inside an RRSP (or tax-free savings account.) However, because everyone's situation is different, you should consult a tax professional.

How can a company pay out more in dividends than it makes in profit?

Ideally, you want a company to pay out only a portion of its profit in the form of dividends. In other words, you want the "payout ratio" to be manageable. This reduces the chance of a dividend cut, which is one of the most unpleasant experiences an investor can have.

Occasionally, however, a company will pay out more than it makes. For example, RioCan REIT has been distributing more than 100 per cent of its funds from operations, and last year Sun Life Financial paid out more in dividends than it made in profit.

Clearly, companies can't sustain a payout ratio of more than 100 per cent forever, but in the short term they can find the money from various sources.

"There are a few ways they can do it. Number one, if a company has an excess cash balance, it can use that to temporarily close the gap," says Pavel Begun, partner at 3G Capital Management in Toronto. "It could also borrow to pay out the difference."

Theoretically, a company could also issue equity to fund its dividend. But eventually something has to give. "Either your operations have to pick up or basically you're going to have to cut the distribution," he says.

While I understand the price-to-book ratio, I have difficulty working it out. Is there a place on your website where it states it simply?

Yes there is. Go to GlobeInvestor.com and enter a stock symbol in the search box (make sure the word "quote" is highlighted). Now scroll down to the section labelled "Financials & Calendar." Here you'll find key ratios including price-to-book, price-to-sales, price-to-cash flow and return on equity.

For the uninitiated, the price-to-book ratio is the price of the stock divided by the book value - or assets minus liabilities - per share. Value investors look for stocks with a low P/B ratio, which can sometimes signal that a stock is cheap. But P/B ratios vary widely by industry, and a low P/B can sometimes signal trouble.

If you scroll up toward the top of the page, you'll find other ratios including the price-to-earnings, PEG (price-to-earnings growth) and dividend yield.

I'm a retired and experienced investor. Some months ago I invested a sizable amount of money in preferred shares of major banks, the rationale being that it would be a safe haven for the cash and produce a steady stream of dividends. They have fallen sharply over the last few weeks. Why?

The facile explanation is that interest rates are rising, so straight preferred shares - which trade much like long-term bonds - are falling. But preferred share expert James Hymas of PrefLetter.com says the tumble in preferreds has more to do with emotion than interest rates.

Short-term rates are indeed rising - the Bank of Canada all but confirmed yesterday that it will hike its benchmark rate on June 1. But long-term corporate bond yields - which are far more important to the preferred share market - are not.

"Long corporate yields have been fairly steady. They have been bouncing around at basically 6 per cent to a little under for the all this year. So whatever concerns there might be about rising interest rates, they're not being shared by the corporate bond market," Mr. Hymas says.

So why are preferred shares falling while long corporate bonds are not?

The corporate bond market is large and dominated by institutional investors such as pension funds and insurance companies that take a long-term view. The preferred market, on the other hand, has a bigger retail presence and many issues are comparatively illiquid. This makes preferred prices more volatile, particularly when retail investors start getting nervous - like now.

Hank Cunningham, fixed-income strategist and investment adviser at Odlum Brown, agrees that fear-based selling may be the primary reason preferreds have fallen. "People are all worried about rising rates, and they're not rising [on the long end]rdquo;, he says. "Rising short rates do not necessarily mean rising long rates."

Have a question for Investor Clinic? Send an e-mail to jheinzl@globeandmail.com

Follow on Twitter: @johnheinzl

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