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What is going on with Canadian Life Companies Split Corp.? Did the class A shares (LFE) just cut their dividend to zero?

The short answer is yes. But to understand what happened here, we need a quick lesson in split share corporations. These complex investment vehicles are marketed to retail investors seeking income, but they can deliver unpleasant surprises, as we’ll see.

Split share corporations – of which there are dozens in Canada – hold a basket of dividend-paying common shares. In the case of Canadian Life Companies Split Corp., the portfolio consists of four of the largest life insurers in Canada. Other split share corporations invest exclusively in banks or energy producers, for example, while some hold a diversified basket of dividend stocks in different sectors. There are even split share corporations that hold stock from a single company.

To raise money to purchase their portfolio of dividend stocks, split share corporations sell two classes of shares to the public: split preferred shares and split capital shares. Each has its own structure and personality.

Split preferreds are the more stable and predictable of the two classes. Generally, they are first in line for the dividends spun off by the underlying portfolio of stocks. Upon windup of the split share company – the securities typically have a termination date that is often extended – the preferreds also have first claim on the capital of the portfolio, up to a certain amount (equivalent to the issue price of the preferred shares). Thanks to these built-in protections, the preferreds usually provide a high level of security, but minimal upside potential. That makes them appropriate for conservative, income-oriented investors.

Canadian Life Companies’ Split preferreds (LFE.PR.B) currently yields about 6.3 per cent, and the shares have paid uninterrupted monthly dividends since their issue in 2005. The market price of the preferreds has also been quite stable, notwithstanding a sharp pandemic-related drop in March, 2020, from which the shares have fully recovered.

The capital (also known as class A) shares, on the other hand, have a different structure that makes them far less predictable. In exchange for giving up most or all of the dividends from the underlying portfolio, the class A shares are entitled to all of the capital over and above the fixed portion allotted to the preferreds. This makes the capital shares effectively a leveraged play on the underlying portfolio.

The leveraged structure is great when stock prices are rising, because the capital shares experience an even bigger gain. But when the underlying stocks are falling, the loss is magnified for capital share investors.

Capital shares also pay dividends, which are funded in part by the sale of call options on the portfolio of stocks. But the class A dividends – unlike split preferred dividends – are anything but stable. Split share corporations typically suspend class A dividends when the net asset value of the portfolio falls below a certain level.

That’s precisely what happened with Canadian Life Companies Split. On March 18, Quadravest Capital Management Inc. – which manages this and other split share companies – announced that no dividend would be paid on the class A shares that month. That’s because, under the terms of the prospectus, regular monthly dividends are suspended “as long as the net asset value per unit is equal to or less than $15,” Quadravest said in a press release. Specifically, as of March 15, the NAV per unit was $14.30. By March 31, it had recovered to $14.80. (Preferred and class A split shares are initially issued as a unit but then begin trading separately; the NAV per unit refers to the combined value of both classes of shares.)

On its website, Quadravest says one of the “highlights” of the class A shares are “targeted monthly cash dividends.” But anyone buying the shares for income would likely be disappointed: Over the past two years the shares have declared a grand total of 20 cents in dividends – 10 cents in each of January and February of this year. Going back five years, the class A shares paid a dividend in just 13 of the 60 months. Moreover, the share price is lower today than it was five years ago. Not all class A split shares have such a dreadful dividend record, but missed payments are not uncommon, especially during rocky periods for the stock market.

Now, if life insurance stocks start to rally, the capital shares should perform well because of their leveraged structure. But that’s an unknown. What’s clear is that, for this particular split share corporation, the preferreds have been the better bet.

As with any security, make sure you understand what you’re getting into before you invest.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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