The ABCs of successful income investing

Years ago, most people would never dream of putting their life savings into securities that didn’t offer cash returns. But the rise of the stock markets and the reduction of the tax on capital gains changed all that. By the end of the 1990s, income securities had become the preserve of the old and the timid.

No more. Three events have combined to create a renaissance in income investing that has given a whole new dynamic to Bay Street.

  • An aging population. Older people are more interested in present-day cash flow than in future capital gains. That has given a big boost to income securities. Given the demographics of our time, this pattern should continue for years to come.
  • The bear market. The crash of 2000-2002 demonstrated in dramatic terms the danger in relying too heavily on stocks to fund your retirement.
  • The emergence of income trusts. A uniquely Canadian security has become the prime mover of our capital markets in recent years. With interest rates so low, demand for the income trust product has soared. Billions of dollars worth of new issues appear annually.


If you are among the growing number of people who are interested in income securities, there are several terms that you need to know to invest intelligently. Here’s a glossary:

Adjusted cost base (ACB): The original purchase price of a security less the value of any “return of capital” distributions received. So if you pay $10 a unit and receive $2 in tax-deferred return of capital payments, your ACB is $8 ($10-$2=$8). The ACB is used in calculating your capital gain or loss for tax purpose when the shares are sold.

Current yield: The return generated by a money market fund at the present time. Some funds calculate this figure on a daily basis, others do so weekly.

Dividend income funds: Mutual funds that invest primarily in dividend-paying securities, typically common or preferred shares. Distributions are usually eligible for the dividend tax credit, although some payments may be classified as capital gains, return of capital, or even interest.

Next page: Effective yield and more

Dividend tax credit: A special credit that is designed to reduce the impact of double taxation on dividend income received by individuals (dividends are paid out of after-tax corporate profits). The credit is calculated by multiplying the actual amount of dividends received by 125 per cent, to produce a “taxable amount”, and then multiplying that result by 13.33 per cent. Only dividends from taxable Canadian corporations are eligible for this treatment.

Effective yield: The projected return on a money market fund over the next 12 months, based on the current yield and assuming all interest is reinvested and compounded weekly.

Exchange-traded fund (ETF): A portfolio of securities that trades on a stock exchange. The term ETF is most commonly applied to index-related securities, such as iUnits, but the broad definition encompasses actively-managed portfolios as well.

Fixed floater preferred shares: Preferred shares that pay a fixed dividend for a period of time and then move to a floating rate that is based on a specified benchmark, usually the prime rate.

Fixed-income securities: Investments for which the payments are guaranteed by the issuer. Examples: Bonds, guaranteed investment certificates.

Floating rate preferred shares: Preferreds whose dividend “floats” with the movement of a base rate, usually prime. Sometimes these preferreds will guarantee a minimum, or “floor”, rate. 

High-yield bonds: Issues that offer above-average yields. These are usually corporate bonds issued by companies with relatively low credit ratings, although the government debt of some developing countries may also fall into this category. High-yield bonds are inherently more risky than government issues.

Initial public offering: The first time shares or units in a security are sold to the public. Usually shortened to “IPO”. Brokerage commissions are not charged on IPO purchases, but they are hidden within the offering price.

Management expense ratio (MER): The total of all fees and expenses charged against a fund, expressed as a percentage of assets. The MER is subtracted from the gross return in calculating the net profit or loss for investors. So if a fund has a gross return of 3 per cent and an MER of 1 per cent, the profit the investor sees is 2 per cent.

Net asset value (NAV): The value of a fund’s assets (at market, not cost) less any liabilities, divided by the number of units outstanding.  So if a fund has $1 million in net assets and has 100,000 shares outstanding, the current NAV is $10.

Premium: The premium to net asset value is calculated by subtracting the net asset value from the market price and dividing by the market price. If the market price is $27.48 and the net asset value is $25.32, the premium is calculated as ($27.48 -$25.32)/$25.32 = .085 or 8.5 per cent.

Retraction privilege: The right to sell securities back to the issuer at a pre-determined price or according to a specific formula.

Return of capital: The technical term for distributions received from an income trust or fund that are tax-deferred in the year received as a result of tax credits and allowances that are flowed through to unitholders. The amount of such return of capital distributions must be deducted from the cost price of the units to arrive at the adjusted cost base (ACB).

Standard deviation: A statistical measure of volatility which shows the extent to which a security deviates from its average rate of return. A security with a high standard deviation has a high degree of volatility. The risk/return ratio is the rate of return divided by the standard deviation for the period. The higher the risk/return ratio, the more favourable the historic performance of the investment.

Structured fund: An income fund in which a portion of the portfolio is placed in a fixed-income security that is designed to ensure that investors will receive their principal at maturity.

Total rate of return: This is the increase in unit value plus distributions divided by the starting unit value. To illustrate: On Dec. 29, 2000, the Citadel S-1 Income Trust closed out the year at $26.25. In 2001, it paid $2.50 in distributions and closed the year at $29. The total rate of return for 2001 is calculated by adding the capital gain and the distributions for the year and dividing by the market price at the start of the year. Thus: ($29.00-$26.25+$2.50)/$26.25 = .20 or 20 per cent.

Variable-income securities: Investments that offer regular income, however the amount of the payments is not guaranteed and will vary according to a number of factors. Examples: income trusts, floating rate preferred shares.