INVESTING
Search for Income
October 31 marks the one-year anniversary of Finance Minister Jim Flaherty’s momentous decision on taxing income trusts. Gordon Powers explores how advisors and investors have weathered the changes as they seek out steady sources of income.
Ever since Ottawa wounded the income trust business with its decision to tax distributions in 2010, investors across Canada have been struggling with how to replace those attractive tax-advantaged income payouts.
The current challenge for advisors, particularly when talking to older clients, is creating a sustainable income stream, in what remains a low interest rate environment, without depending on the juicy cash flow that income trusts provided.
“I don’t really see that things have changed all that much,” says Andy Glavac, a CFP and principal of Glavac Financial Services in Welland, Ont. “The key to success has always been to draw income from a diversified asset base. Income trusts are, and continue to be, just one component. Nobody should be scrambling around trying to replace anything.”
While many investors clearly fell in love with trusts’ double-digit yields and enticing capital appreciation, it’s up to advisors to rein clients in and protect them from their own exuberance, he says: “If they were overexposed when the rules changed, then the advisor has to shoulder much of that responsibility. If you want to be successful, it has to be more about planning, not product.”
While several of his clients do hold income trusts, largely in the form of income funds, he prefers funds that derive most of their yield from dividend-paying blue-chip stocks and preferred shares issued by the big banks or financial services companies such as Manulife Financial.
“Regular dividends are viewed as a sign of financial health and companies that pay them are usually larger, with more stable balance sheets and less risk,” he says. “With a well-diversified fund portfolio, you’re getting good income, growth potential and some downside risk — that’s really what people are looking for.”
Such a list, for instance, might include AGF Dividend Income Fund or Dynamic Dividend Income Fund, designed to hold roughly 25 per cent of its assets in four categories — high-yielding common shares, preferreds, income trusts and bonds.
Right now, Dynamic’s Michael McHugh has allocated 36 per cent of the fund to equities, 27 per cent to income trusts, 27 per cent to bonds and convertible debentures, five per cent to preferred shares and five per cent to cash. That said, fund rater Morningstar Canada actually labels its sister offering, Dynamic Dividend, as more appealing given its lower fees, longer track record and similar investment strategy.
“Dividends often get overlooked when markets are running like they have been in the past several years,” says Morningstar senior fund analyst Mark Chow. “But, should things take a turn for the worse or even normalize, funds that hold stable dividend-paying stocks that can grow their dividends tend to do well.”
Dividends also provide some support for stocks in falling markets, he adds, pointing to the effect of reinvested dividends when comparing the performance of the S&P/TSX Composite Total Return Index (TR) to that of the Capital Appreciation Only (CA) version of the index. Over the past 20 years, the TR has returned 10 per cent on an annualized basis, while the CA has earned roughly seven per cent.
“While three per cent may not seem like much when returns are in the mid-teens, an extra 300 basis points is nice when your expected return is in the single digits,” Chow points out.
“I’m really not a great believer in this sort of managed product,” says Adrian Mastracci, RFP and portfolio manager with KCM Wealth Management in Vancouver. “The MERs on most of these income funds are too high so I tend to skip them — although some of the dividend variety are more fairly priced.”
His approach is to keep the fixed-income portion of the portfolio simple while minding the costs. That means maturities of up to five years in this environment, in a ladder format, with a couple of maturities per year.
“For the short end, you could have treasury bills and, for up to five years, federal and provincial strip coupons. There are ETFs (exchange-traded funds) as well for investors who want a basket approach. For those who can stand the additional risk, a basket of dividend-paying stocks and a few rebounding income trusts would be my choice.”
This is particularly true now that the federal government has lightened the tax load on dividends. Federal tax changes, which were matched by Ontario last year, put the highest tax rate for dividends at around 21 per cent (down from 31 per cent) versus about 46 per cent on regular income, including interest income.
“Although the numbers vary slightly from province to province, the math is similar,” says Mastracci. “Investors have done very well, and will now do a bit better, by buying high-quality dividend stocks. This should be the focus.”
And this includes preferred shares as well, he adds, particularly for conservative clients. Preferred shares tend to pay higher dividends than regular common stocks and, while they do move up and down in price, they’re not nearly as volatile as common stocks. Preferred shareholders are also entitled to payment of dividends before common shareholders get theirs.
Earlier this year, $600-million worth of preferred shares were issued by two of the big banks, Royal Bank of Canada and Bank of Montreal. They were priced to yield 4.5 per cent, a tad better than a government bond or GIC before tax. But, after applying the tax credit, an Ontario resident would need a bond yielding close to 6.3 per cent to get the same after-tax return, explains James Hymas, president of Toronto-based Hymas Investment Management. And that’s not easy to come by.
“Preferred shares are an excellent option for income seekers. They’re particularly attractive to Canadian banks when raising capital and we expect even more product to come to market this year,” says Hymas, manager of Malachite Aggressive Preferred Fund. “Retail interest is certainly growing again since income trusts have been tarnished.”
Investors can assemble their own mix of preferreds, as long as they stick to those that are investment grade, or opt for a closed-end fund such as Sentry Select’s Diversified Preferred Share Trust or RBC Dominion Securities’ Advanced Preferred Share Trust. Essentially passive plays, these funds start out with a predetermined mix of preferred, replacing them only once they’re matured. The Malachite fund, however, is more actively managed.
Where do preferreds fit? Hymas believes investment-grade issues can be used almost interchangeably with bonds. “Years of data tell us that the risk/reward equation is quite similar, tax issues aside.”
In fact, even under the previous tax regime for dividends, preferred shares actually had an edge on an after-tax basis. From 1994 to 2003, they produced a 4.05 per cent annualized after-tax return versus 3.55 per cent for the Scotia Capital Corporate Bond Total Return Index, his research says.
Sure, with stocks you’re an owner and with bonds you’re a lender, but for some investors, stocks of any type are not the answer — even though bond yields remain fairly low and the interest earned is fully taxable. For one thing, bonds do offer a greater predictability of income when compared to dividends.
“Bonds are all about stability,” says Adrian Mastracci. “They have a return you can count on and provide some downside protection from shaky markets. The reason to diversify is not necessarily to increase your income, or even lower your risk; it’s to insure against the unforeseeable.”
But don’t look for big jumps in price, says Glavac, who expects bonds to deliver coupon returns and not much more for the next while. “That means, for more cash flow, investors may have to take a bit more risk than in the past.”
Still, State Street Global Advisors strategist Krisztina Kaplony sees “lower interest rates in the near term, exacerbated by the ongoing strength of the Canadian dollar. We anticipate a softer landing for Canada, with the Bank of Canada easing rates less and later than the Fed.” In other words, she suggests, a mildly positive environment for bonds.
There are various types of bonds to choose from, including provincial and federal government issues, corporates and real-return bonds. Buying individual bonds can make a lot of sense for investors willing to hold them to maturity, but a fund clearly offers greater diversification across lengths of terms and sector. And, for retail investors, most bond brokers take a significant spread, lowering yields further.
Another option is to replace individual bonds with inexpensive ETFs. There are several listed on the Toronto Stock Exchange, including two that replicate the yield on a five- or 10-year Canada bond. MERs range from 30 to 40 basis points.
But, for investors committed to monthly contributions, ETFs are not a cost-efficient alternative, Chow warns: “In most of these cases, a good low-fee fund is the way to go.”
His favourite: PH&N Total Return Bond offered by Phillips Hager & North Investment Management of Vancouver. Unlike many other bond funds, its strategy allows for the limited use of derivatives and a small amount of lower-quality debt. As well, the fund’s MER of 0.61 per cent is lower than the median Canadian Bond fund by nearly a full percentage point.
The fund can pick up lower credit quality bonds via PH&N High-Yield Bond, which is predominantly comprised of lower-rated, higher-yielding bonds. Right now though, less than two per cent of the fund is in that sector with roughly 40 per cent in government securities. The fund is also underweight in corporate bonds, adopting a defensive posture by concentrating on a shorter average maturity and higher quality issues.
Truth be told, the majority of advisors are still more comfortable delegating portfolio construction to the fund companies. As a result, a growing number of vendors have introduced “T” versions of their funds, paying out a predetermined annual percentage of assets in the form of a regular monthly income stream.
However, these T funds are less flexible than established systematic withdrawal plans (SWPs), which allow investors, not the fund company, to determine the income stream.
Investors with regular SWPs need to cash out units to create that income, which typically results in taxable capital gains. T funds go one step further though, providing an even more tax-efficient stream of income since a significant portion of the payout is classified as return of capital. Investors receive a regular monthly cash flow without redeeming units and without triggering personal capital gains until the units are sold or the account’s adjusted cost base drops to zero. Of course, some portion of the distributions will likely be generated by dividends or interest as well, both of which are taxed at their usual rates.
This is particularly significant for older investors since return of capital is not considered income for the purposes of calculating social benefits like Old Age Security, the GST credit and the age credit.
“Although it certainly doesn’t impact everyone, the OAS clawback is a very real concern for more affluent clients,” says Adrian Mastracci. “For them, assuming they’re going to be buying the funds anyway, a T-series may hold more appeal.”
Analysts caution, however, that investors considering T funds need to take a hard look at past performance to ensure that the intended distribution is realistic. If not, the fund manager may be forced to dip into capital to maintain the distribution or actually lower the distribution rate — precisely what beleaguered income trust investors are hoping to avoid.
“Sustainability is a big issue for any funds with regular distributions. If the payout is eight per cent, for example, this is going to mean a big dent in value during a down year,” says Mark Chow. “Advisors have to emphasize that these payouts are based on “best efforts” targets and that they’re not guaranteed. Otherwise, we’re going to end up with the same sort of shakeup we’ve seen in the income trust market.”
Consider Clarington Canadian Income fund. Prior to August 2002, the fund was paying a fixed distribution of $0.08 per month, just shy of 10 per cent of net asset value per share, wrung from a conservative asset mix of roughly 50 per cent fixed income and 50 per cent equity. This worked well for a time based on solid returns but, after a while, Clarington was forced to cut its distribution to a more realistic $0.06 per month, disappointing many investors along the way.
Seg Fund SurgeIt is counterintuitive that segregated funds sales have been rising through one of the most impressive bull markets in history. Another factor is undoubtedly at play — demographics and the general aging of the population. As baby boomers enter retirement in increasing numbers and find that greater longevity necessitates higher returns to meet income objectives, they are turning to seg funds to meet that need. Canadians over age 65 comprised a record 13.7 per cent of the population in 2006 and that number is growing. Not surprisingly, seg fund sales are rising too and in 2007 are set to overtake the $3.4 billion in net sales recorded the previous year. Net sales for the year to June 2007 were an impressive $2.9 billion, according to Investor Economics — far ahead of the $2.5 billion in net sales recorded to the end of September 2006. As roughly 3.6 million Canadians reach the age of 65 over the next decade, seg funds could allow retired investors to extend the time horizon over which they can remain invested in equity markets. This issue is especially acute given the absolute fall in bond yields over the past two decades. The reality is that investment grade bonds, the safest grade of fixed income investment, no longer provide enough income or potential capital gains for investors looking forward. They may prove to be useful securities for preserving capital, but that is the extent of the opportunity. Many investors undoubtedly turn to seg funds in pursuit of equity market returns with an element of principal protection. They offer exposure to equity markets with maturity guarantees typically ranging from 75 per cent to 100 per cent of invested principal and payouts upon death or contract maturity. Since many seg funds allow investors to lock in market gains at regular intervals thereby increasing their guaranteed payout, they are attractive to risk-averse investors interested in equity market exposure. Seg funds have additional features that provide capital protection in the form of creditor-proofing investments in the event of bankruptcy or negative judgments due to lawsuits. They also allow for the invested assets to pass directly to a named beneficiary in the case of death. This can mean the avoidance of costly estate taxes and probate fees. There are now more than 2,000 seg funds on offer in Canada with a variety of different features that makes these insured investment vehicles far more sophisticated than the first funds offered a decade ago. For example, the newest innovation in segregated funds offers guaranteed minimum withdrawal benefits (GMWBs). Investors are entitled to guaranteed withdrawals to a minimum of invested principal over a set number of years. GMWBs offer annuity-like payouts yet are still linked to market returns, so market gains will translate to higher minimum annual payouts. The win-win proposition of segregated funds is, of course, tempered by the higher fees associated with the guarantees. Fees are noticeably higher, in some cases one to two per cent higher, than for plain-vanilla mutual fund fees and these will cut into potential returns. Initial sales charges and trailing sales commissions also apply, much as they do for mutual fund investors. Portfolio diversification reduces the need for principal protection, but when it comes to investing in equity markets in retirement, many investors demand the added protection afforded by seg funds. If seg funds allow risk-averse investors to access a market they would otherwise shrink from, then these protected investment vehicles warrant a place in those investors’ portfolios. |