The yields on preferred share exchange-traded funds look very appealing. The BMO Laddered Preferred Share Index ETF (ZPR), for example, yields about 6.7 per cent, and the iShares S&P/TSX Canadian Preferred Shares Index ETF (CPD) yields about 6.1 per cent. Do you think their dividends are sustainable?
I’m skeptical. The reason preferred yields are so high is that preferred share prices have tumbled (prices and yields move in the opposite direction). And one reason prices have tumbled is that the market is dominated by rate-reset preferreds, whose dividends are adjusted every five years based on a predetermined yield spread over the five-year Government of Canada bond yield.
With the coronavirus flattening the global economy and central banks slashing interest rates, the five-year bond yield has plunged to a near-record low of about 0.44 per cent (as of Friday afternoon). That’s a problem because, if bond yields remain low, companies that reset their preferred dividends over the next few years could reduce their payouts.
We saw this the last time government bond yields went for a skid. ZPR, for example, was paying 5.3 cents a month in dividends at the start of 2014. By September of 2017, ZPR’s monthly payout had dropped to 3.5 cents – a 34-per-cent haircut.
The ugly action in the preferred share market suggests investors are fearing a repeat performance. Through the first three months of 2020, the S&P/TSX Preferred Share Index posted a total return – including dividends – of negative 22.8 per cent. The drop may also reflect general worries about the economy and the financial health of certain companies.
I’m not saying preferred shares are necessarily a bad investment right now or that the dividend reductions will be as severe this time; the shares might turn out to be a good bet if the world gets back to normal and bond yields rebound. Indeed, preferred prices have recovered from their lows in late March, signalling that some investors see opportunity.
But higher yields come with higher risks, and the risk right now is that some rate-reset preferreds will reduce their payouts at some point in the future. So keep that in mind if you’re tempted by the high yields of preferred share ETFs.
For an interlisted stock such as Royal Bank of Canada (RY) that trades on both the Toronto Stock Exchange and New York Stock Exchange, if I believe the Canadian dollar is going to fall to about 60 US cents because of the pandemic, would it make sense to buy Royal Bank on the NYSE to profit from the change in the exchange rate?
No. Presumably what you are suggesting is that, when you sell Royal Bank and convert the U.S. dollar proceeds back into (cheaper) Canadian dollars, you’ll come out ahead. But you are only looking at one side of the currency impact.
Let’s assume, for simplicity, that Royal Bank’s share price will remain more or less steady on the TSX. If your currency prediction is correct and the Canadian dollar falls then – all else being equal – Royal Bank’s share price on the NYSE will also have to fall. Why? Well, the flip side of a falling Canadian dollar is a stronger U.S. dollar, and investors would now need fewer U.S. dollars to purchase a share of Royal Bank. So what you gain from a falling Canadian dollar you lose in Royal Bank’s lower share price on the NYSE.
This is a simplified example, but the lesson is that you can’t use interlisted stocks to capitalize on fluctuations in the exchange rate. The currency effects cancel each other out.
But there’s another – more important – reason to buy interlisted stocks on the TSX: You avoid currency conversion costs. Every time you convert Canadian dollars to U.S. dollars, or vice-versa, your broker effectively dings you for roughly 1 per cent to 2 per cent of the trade value by buying or selling the currency at a rate that is favourable to your broker – and not favourable to you. So buy your interlisted stocks at home and save your money.
I am aware that withholding tax on U.S. dividends can be avoided if one holds U.S. stocks in a registered retirement savings plan or registered retirement income fund. Does this exemption also apply to registered disability savings plans?
No. Under the Canada-U.S. tax treaty, only accounts that specifically provide retirement income are exempt from withholding tax on U.S. dividends. These accounts include RRSPs, RRIFs, locked-in retirement accounts, life income funds and other registered retirement accounts. RDSPs are not considered retirement accounts and are therefore subject to withholding tax on U.S. dividends. Withholding tax also applies to non-registered accounts and – this often surprises people – to tax-free savings accounts and registered education savings plans. The withholding tax rate is typically 15 per cent of the dividend. (This assumes your broker has filed a W-8BEN form with the Internal Revenue Service on your behalf, which brokers usually do automatically. Otherwise, the withholding tax rate is 30 per cent.)
E-mail your questions to email@example.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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