Finance & Investing: Generating Income

By: Gordon Pape

It’s tough to find good-quality income securities these days. Interest rates are at the lowest levels since the Great Depression. Income trusts, once

a mainstay for income investors, are rapidly disappearing as the implementation date for the new tax approaches. The market plunge has left many people frightened of even top-quality dividend-paying stocks.

It is still possible to earn enough income from low-risk securities to offset the minimum withdrawal until age 70, although you must be skilful and somewhat imaginative in building a RRIF/LIF portfolio. Once you reach age 71, the only way to prevent the erosion of principal is to earn capital gains,
which means adding more risk to your mix. (CARP has been fighting to
change the minimum withdrawal rules for RRIFs.)

What can you do in this situation?

> For starters, minimize your cash holdings (money market funds, savings accounts, etc.). Yes, cash is a safe haven, but I would limit your position to no more than the amount you intend to withdraw for your personal needs over the next six months. With short-term interest rates so low, cash is “dead money” right now.

> You should not avoid interest-bearing securities entirely because of the stability they bring to an investment portfolio. But squeeze out every basis point of return that you can (a basis point is one-hundredth of a per cent). For example, if you invest directly in bonds, look for high-quality corporate issues, which currently offer much higher yields than government bonds. If you prefer GICs, search out the small financial institutions, which offer better rates than the big banks. As of early September, several companies were offering five-year rates that topped Royal’s 3.26 per cent. (For a complete list of current GIC rates, visit Globeinvestor.com.)

> For this purpose, I strongly recommend preferred shares, sometimes called “preference shares.” In normal times, these are a safe albeit dull way to earn steady cash flow without undue risk. However, the past couple of years were anything but normal. Preferred shares took a beating in 2008, with the S&P/TSX Preferred Share Index falling a staggering 21.4 per cent. I cannot remember any period in which preferreds suffered losses of that magnitude.

Why did it happen? There were two main reasons. The first was the widespread panic that took hold in the summer and fall of 2008 as stock markets around the world cratered. It was a grim time: the global banking system appeared to be on the verge of collapse, countless Americans were being forc-
ed out of their homes and economists were warning of the possibility of a lengthy depression.

Some people responded by selling every stock they owned and fleeing to the perceived safe haven of government bonds. Even usually rock-solid preferred shares were caught up in the selling frenzy. They weren’t hit as hard as common stocks, but the damage was severe nonetheless.

That storm has now passed. Preferreds rallied in the first half of this year, with the Preferred Share Index gaining 12.6 per cent. New issues of bank preferreds are coming to market at much lower rates, driving up the prices of last fall’s issues and earning capital gains for investors in the process.

To illustrate, in November 2008, the Bank of Montreal announced it was issuing up to $250 million worth of Class B Series 18 preferred shares paying a dividend of 6.5 per cent for the first five years. The offering price was $25 a share. The shares trade on the TSX (BMO.PR.N) and at the time of writing they were priced at $27.77. So investors who bought on the initial offering are enjoying great cash flow plus a capital gain of more than 10 per cent.

In June of this year, the Bank of Montreal came out with another issue of preferreds (Series 23). The dividend for the first five years was down to 5.4 per cent, which shows how much the market changed in the intervening six months. But I expect that even that lower yield will look attractive a year from now.
> The point is that although the preferred share market has rebounded, income-oriented investors can still find good-quality issues that pay five per cent or higher. If you hold the shares outside a registered plan, they will be worth even more because the payments qualify for the dividend tax credit. That means you’ll keep more money in your pocket.
For example, a resident of British Columbia with $50,000 in taxable income will pay only $4.40 in tax on every $100 of eligible dividends received, according to Ernst & Young’s 2009 Personal Tax Calculator. The rate will vary depending on where you live but will always be less than what you’ll pay on interest income. And where are you going to earn five per cent interest these days without taking big risks?