An Investment That Never Stops Paying

01/23/2012 11:15 am EST

Focus: INCOME

Rob Carrick

Columnist, The Globe and Mail

Investors impatient with low bond and Treasury yields can up the ante, but there are tricks to reaping a high-yielding and relatively secure flow of dividend income, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Hard times for the insurance industry have created an opportunity for investors who are tired of low bond and GIC yields.

Look to the perpetual preferred shares issued by Sun Life Financial (Toronto: SLF), Manulife Financial (Toronto: MFC), and to a lesser extent, Great-West Lifeco (Toronto: GWO). At current prices, these shares offer yields in the area of 4.5 to 5% and the potential for a small capital gain down the road.

Like many savers and investors, life insurance companies are struggling as a group these days as a result of low interest rates. Insurers manage investment portfolios to help them meet financial obligations to policyholders, and low rates are dragging returns down. Profits must be diverted to boost reserves, and that can mean ugly overall financial results.

In Sun Life’s case, investors have reacted by driving the company’s shares down by roughly one-third in the past 12 months. The dividend yield on the common shares was just above 7% at mid-week, which is extraordinarily high for a blue-chip financial firm…and a clear sign investors are worried about a dividend cut.

Manulife halved its dividend back in the summer of 2009, so concern about a dividend cut at Sun Life is not unfounded. But if you own the company’s preferred shares, you’re largely insulated.

If a company must conserve cash, dividends on common shares have to be cut ahead of preferred shares. Preferred share dividends can be hit as well, but that usually requires a corporate near-death experience. Note: If a company folds, bondholders will get paid before preferred shareholders.

Opinions vary on whether preferred shares should be counted as bonds or stocks in a portfolio, but here we’ll treat them as bond-like. In fact, the reason to own preferred shares is to generate reliable dividend income. Though they can fluctuate in price, preferred shares don’t generally give you the kinds of ups and downs that common shares do.

Complexity is a huge drawback for investors when considering preferred shares. Many blue chips have multiple series of preferred shares, each with much different characteristics.

Perpetual preferreds, where there’s a particular buying opportunity today in the life insurance sector, are in a way the least appealing sub-category. Think of a perpetual preferred like a corporate bond with no fixed maturity date. Other types of preferred shares have set dates when the issuing company will redeem them at the issue price, usually $25.

"Perpetuals could be paying out that dividend as long as you live," said James Hymas, president of Hymas Investment Management and an expert on preferred shares.

One reason why Hymas likes insurance company perpetuals right now is that they offer a high-yielding and relatively secure flow of dividend income. Preferred shares issued by Sun Life, Manulife, and Great-West Lifeco are investment grade, although Standard & Poor’s has Sun Life on negative credit watch. Investment grade means a low probability of default.

Hymas also sees an opportunity to buy insurance company perpetual preferreds now and benefit from possible rule changes by regulators concerning the financial structure of this sector.

Banks have already been subjected to these changes, which largely eliminate the attractiveness for them of raising money by issuing preferred shares. As a result, it’s widely expected banks will gradually redeem their preferred shares over the next decade, including perpetuals.

Many in the financial world expect that regulations for life insurance companies will be harmonized with the banks. "If so," says analyst Tara Quinn of the ScotiaMcLeod Portfolio Advisory Group, "then insurance company perpetuals could be a best buy right now."

Insurance company perpetuals typically trade in the $22 to $24 range these days. If the regulatory changes come through as anticipated, then investors can expect to have these shares redeemed at the usual $25 redemption price at some point in the next ten or so years. This creates an opportunity for a capital gain bonus on top of those high dividend yields.

There are two ways to measure the returns from preferred shares, the first being current yield. You calculate this using the price you paid for your shares and the annualized dividend.

The more useful gauge is "yield-to-worst," which is derived from the flow of dividends and the difference between the price you pay for the shares and a worst-case estimate of what you’d get on redemption.

If you buy preferred shares for more than the redemption price, then your yield-to-worst is lower than your current yield. In the opposite case—and that’s where some life insurance perpetuals are—the yield-to-worst is higher. By Hymas’s calculation, the yield-to-worst on insurance company perpetual preferred shares can be as high as 5.9% or so.

Prepare for a bumpy ride between now and any redemptions triggered by possible regulatory changes. Interest rates are the major risk. In fact, one of the reasons why perpetuals aren’t an investor favorite is that they’re highly vulnerable to rising rates.

Quinn said that some insurance company perpetuals have a "duration" of close to 18, which is to say that a rise in interest rates of one percentage point would in theory cause it to fall by 18% in price.

Duration is a standard measure of how vulnerable fixed-income investments like bonds and preferred shares are to moves in interest rates. A short-term bond might have a duration of 2 or 3.

Holding insurance company perpetuals through an upturn in rates may not turn out quite that bad, however. Quinn said insurance companies tend to perform well during periods of strong economic growth, and that may help offset the influence of rising rates on their preferred shares.

As far as Sun Life goes, there’s also the worry of a reduction in the common share dividend. Truth is, cutting the amount of cash paid out to common shareholders helps ensure there’s enough money to pay preferred shareholders. But Hymas said holders of the preferred shares should still expect some turbulence.

"People see a dividend cut and they instantly assume the preferred shares will be affected," he said. "Typically, what will happen is that there will be a period—six months to a year—where the preferreds are depressed."

Perpetual preferred shares from life insurance companies aren’t for nervous investors, then. But if you can hold on through some ups and downs, they may just pay off in a way that more conservative bonds and Treasuries can’t match.

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