I’m hoping you could comment on Dividend 15 Split Corp. Its class A shares yield more than 15 per cent, but the companies it invests in only yield about 5 per cent, on average. This seems too good to be true. What am I missing?
When a yield soars well into the double digits, there’s always a catch. Let’s lift the curtain and see how that supersized yield is generated.
Like other split-share corporations – of which there are a couple of dozen in Canada – Dividend 15 Split issues two classes of shares to investors: preferred shares DFN-PR-A and class A shares DFN-T, also known as capital shares.
Split preferreds are the more conservative of the two. Generally, the preferreds are first in line for the dividends – up to a certain level – spun off by stocks in the underlying portfolio, which in this case is a basket of Canadian banks, pipelines, telecoms, utilities and other dividend-paying companies. Upon windup, the preferreds also get first claim on the capital in the portfolio, up to their issue price. (Dividend 15 Split has a termination date of Dec. 1, 2024, but split-share corporations typically extend the date in five-year increments.)
Reflecting these safety features, split preferreds provide steady income but little upside potential. Although their bond-like characteristics make them sensitive to rising interest rates, volatility is generally modest. Dividend 15 Split’s preferred shares currently yield about 5.9 per cent.
The class A shares – also known as capital shares – are much less predictable. Essentially, they are entitled to all of the value in the portfolio over and above the fixed amount allotted to the preferreds. Because of this leveraged structure, if the underlying stocks rise, the class A shares generally experience an even larger gain. But the reverse is also true: If the underlying stocks fall, the class A shares will have a larger decline.
What’s more, the class A shares are required to suspend dividend payments if the net asset value of the split-share corporation falls below a certain threshold, which in Dividend 15 Split’s case is $15 per unit. (A unit consists of one preferred share and one capital share.) That’s precisely what happened in 2020 when the pandemic-induced market selloff prompted Dividend 15 Split to suspend dividends on its class A shares in April, May, June and November of that year. The split preferreds, on the other hand, didn’t miss a single payment.
So where does the cash come from to pay the outsized dividends on the class A shares?
With split capital shares in general, there are typically three sources of funds: any excess dividend income from the underlying portfolio (after the preferreds have received their fixed cut); premium income from writing covered-call options on stocks; and capital gains in the portfolio.
It’s important to understand, however, that the fat yield on the class A shares is not a free lunch. With so much cash going out the door every month, DFN’s share price has been grinding lower for years. In the five years ended Dec. 31, for example, DFN dropped about 30 per cent, even as Canada’s benchmark index rose almost 20 per cent. So, while investors have been collecting a juicy dividend, they’ve effectively been subsidizing the payout with an erosion of their own capital.
When you combine DFN’s high yield with its falling stock price, its return suddenly looks very ordinary. For the five years through Dec. 31, DFN’s annualized total return was 6.49 per cent, according to the compound returns calculator at canadastockchannel.com. (Total returns assume all dividends were reinvested in additional shares.) A low-cost exchange-traded fund that tracks the S&P/TSX Composite Index would have produced a virtually identical result. Granted, an index ETF won’t generate the same level of cash flow, but investors can achieve a similar result by periodically selling a portion of their securities. (Tip: Use a broker that offers commission-free ETF trades.)
What’s more, Dividend 15 Split’s net asset value per unit has also been trending lower. For the five years through 2016, the NAV averaged about $19.60. In the following five years, it averaged $17.50. (These figures are based on the NAV per unit at Nov. 30 each year, as provided in Dividend 15 Split’s annual management report of fund performance.) As of the latest update, on Dec. 30, 2022, the NAV per unit had dropped to $15.45 – uncomfortably close to the $15 threshold at which dividends on the class A shares are suspended − although the NAV has likely risen since then along with the broader market.
So, before you jump into a split-share investment such as DFN, consider the big picture: Yes, you’ll be getting a large dividend, but you’ll also likely face increased volatility, potential long-term erosion of the share price and the risk that dividends will dry up if things get ugly out there.
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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John Heinzl