With talk of recession risks on the rise, investors are getting nervous about bank stocks.
You can see this in the fate of the $1.1-billion BMO Equal Weight Banks Index ETF (ZEB). In August, it led all mainstream ETFs in outflows with a decline in of $212-million.
The ZEB sell-off makes sense to some extent – loan losses would rise in an economic downturn and increasing revenues to fund future dividend increases would be tougher than ever. But if you’re a yield-focused investor, ZEB and its underlying banks have some appeal.
ZEB’s yield as of the second week of September was just a tick below 4 per cent, which compared with 1.5 per cent for a five-year Government of Canada bond and the high 2 per cent range at best for guaranteed investment certificates (though Oaken Financial was at 3 per cent as of Sept. 10). In non-registered accounts, ZEB’s yield looks all the more impressive because of the dividend tax credit. Bond and GIC income is treated less advantageously when held in taxable accounts.
Bank stocks might get thrashed at some point, so the risk level in holding ZEB is considerable. But lots of income-seeking investors have veered out of bonds/GICs and into stocks in search of income in recent years. In some cases, they have bought preferred shares; in others, shares of blue chip companies like banks, electrical utilities and pipelines.
You’d think preferred shares would have been the more conservative play for these yield-seekers, but that’s not how things have played out. For reasons I outlined in a recent column you can read here, pref shares have been nasty. While ZEB had a pretty bad time of it in the past 12 months, losing 5.5 per cent on a total return basis, the BMO Laddered Preferred Share Index ETF (ZPR) lost 16.8 per cent over that same period.
If interest rates fall further because of concern about the economy, expect both banks and preferred shares to suffer. Likewise, both have rebound potential when the economy and rates stabilize. But ZEB is the more appealing choice if your goal is not just dividend income, but also dividend growth. As its bank holdings have increased their dividends, so has ZEB hiked its monthly payouts over the years. You won’t get that kind of steady dividend growth from preferred shares.
ZEB’s biggest drawback might be its pricey management expense ratio of 0.62 per cent. That’s the price you pay for the convenience of tapping into the dividend production of the Big Six banks in one purchase.
-- Rob Carrick
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Ask Globe Investor
Question: I’m planning to make a donation of $10,000 to a local charity, either with cash or securities. My adviser is happy with the current balance in my portfolio and doesn’t think we need to sell anything. However, I suggested that I could donate securities to take advantage of the tax break on capital gains and then use some of the cash in my account to repurchase the shares to keep my investment mix the same. Do you see any flaws in this approach?
Answer: Donating listed securities that have appreciated in value is a win-win. The charity receives funds to spend on worthy causes, and you get a donation tax credit and - thanks to a further tax break on in-kind donations of listed securities - avoid capital gains tax on any appreciation in the value of the shares. Even though this tax relief on capital gains has been available since 2006, many investors aren’t aware of it.
“Donating securities ‘in-kind’ is perhaps the most missed opportunity in charitable giving,” says Jamie Golombek, managing director, tax and estate planning, with Canadian Imperial Bank of Commerce.
“I call it ‘tax-gain donating’,” Mr. Golombek says. “While most of us might be more familiar with the concept of tax-loss selling, which involves crystallizing a capital loss so it can be used to shelter capital gains, tax-gain donating involves crystallizing gains on winning stocks or mutual funds by donating them ‘in-kind’ to charity.”
Here’s how it works. Say you plan to donate $10,000 of shares that have an adjusted cost base of $2,000. If you were to sell the shares first and donate the cash, you would have to pay tax on the $8,000 capital gain. Assuming your marginal tax rate on regular income is 50 per cent, you’d pay capital gains tax of 25 per cent - or $2,000.
But if you instead donate the $10,000 of shares, no capital gains tax applies. What’s more, in both cases you would also receive a charitable donation receipt for $10,000. Depending on the province or territory, your gift would produce a charitable donation tax credit worth at least 40 per cent, or $4,000. (This assumes you have already made $200 in charitable donations, as the charitable tax credit is significantly higher above this threshold.)
Wondering how large your tax credit would be? The federal government has an online charitable donation tax credit calculator at http://bit.ly/2kuKRey The government also maintains a database of charities and other qualified donees that can issue official receipts for donations. Find it here http://bit.ly/2kHtB5N
Here a couple of things to keep in mind. Only listed shares (or other eligible securities such as listed bonds or fund units) that are held in a non-registered account can be donated. You may claim the entire donation credit in the current year, or spread it over the next five years. “You would only do this if you are caught by the donation income limitation, which generally limits donations in a year to 75 per cent of your net income, which is not a problem for most of us,” Mr. Golombek says. Either way, the charity receives the full value of the gift immediately.
Regarding your plan to repurchase the securities in your account, it makes perfect sense, Mr. Golombek says. “You get the donation tax receipt, pay no tax on the capital gain to date and increase the adjusted cost base of the securities back up to their current fair market value, reducing your ultimate tax bill on a future sale,” he says.
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What’s up in the days ahead
For the first time in this decade-plus bull market, value stocks are suddenly springing back to life - leaving momentum and growth investments in the dust. But a closer look at the long term should leave little optimism this trend has staying power. Ian McGugan will explain why.
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Compiled by Globe Investor Staff