"Is that the symbol for the Illuminati? CONSPIRACY."

“Is that the symbol for the Illuminati? CONSPIRACY.”

Here’s a question for you guys.

How do you sleep at night?

No, dammit. That’s not right. Are you going to stop DICKING AROUND and actually ask the question?

Who are you talking to?

I don’t know. Let’s get to the damn question.

Why exactly would you own bonds in a portfolio?

There are a few reasons, like:

  • Interest payments, yo. Even if they do suck these days
  • Balancing the portfolio
  • Take some of the risk off equities

These days, owning bonds is less about the yield and more about the affect they have on a portfolio. When stocks go down, investors rush into bonds faster than a fart clears out an elevator. The price of bonds go up, which nicely mitigates equities going down.

If you’re owning bonds for the yield, you better be prepared to hold individual bonds to maturity. If you buy a bond fund, there’s the risk of that thing going backwards in a hurry if rates go up. Basically, you need to just buy the bonds and tuck them away for a while and not pay attention to the price of the asset at all.

So what are the alternatives if you’re looking for yield?

Dividend growth stocks are the bee’s knees right now. It makes sense. Say you bought Shaw Communications shares today, which yield 4.3% and you think can raise the dividend by 5% a year. Ignoring the share price, here’s what you’d have after five years.

Year Yield on Cost
1 4.3%
2 4.5%
3 4.7%
4 5.0%
5 5.2%

Not bad, right?

Of course, it isn’t all just rainbows and sunshine. Many of these dividend growth stocks are overvalued because retirees are using them as bond proxies. It’s all fine and good if you can really ignore the share price when the next bear market hits, but we all know many investors will freak the hell out the next time things start to look bad.

There’s a reason why I picked Shaw Communications. People are cutting the cord on cable┬áin favor of things like Netflix at the rate of 2-3% per year. It’s sort of like the cigarette companies. At this point, they can increase prices faster than people are going away, but this could change.

The issue with Shaw (or any other dividend growth company) is simple. There’s upside potential, but also the risk the business deteriorates.

But there’s a third option for folks looking for income, one with a pretty decent built in advantage. Yep, I’m talking about the preferred share.

Here’s why you should own preferred shares, in one simple to digest tidbit. Feel free to cut and paste this next sentence into everything you do from now on. It’s okay, your kid’s teacher will understand.

Preferred shares are like bonds, but on steroids.

Here’s how a preferred share works. It’s basically a half-bond half-equity hybrid that trades on the stock exchange. They tend to be a little more volatile than bonds, but investors are compensated for it by getting more yield.

Let’s do an apples-to-apples comparison, with our BOY Prem Watsa’s baby, Fairfax Financial. Fairfax has bonds due in 2021 that currently yield 3.77%. They started out with a coupon (the original interest rate) of nearly 7%, but the bonds have gone up so much that you only get less than 4% annually once you factor in the capital loss. Remember, these bonds will be paid back at 100, and they currently trade at 116.

Meanwhile, let’s compare that to the Fairfax preferred shares, specifically the series E prefs. That’s what us cool kids called preferred shares, btw. Go ahead and copy us, it’s okay.

The preferred currently trades at $15.00, paying out a dividend of $0.1818 per share per quarter. That’s a yield of 4.85%, which beats our bond yield nicely. So why is that?

Bondholders are always the first to get paid back if the company goes under. Less risk = less reward. Also, if the company runs into difficulty, it’ll stop making the dividend payments on the preferreds before it stops with the bonds.

Secondly, these preferred shares are what’s called a rate reset preferred. Which means that every five years, the interest rate gets adjusted. These shares just reset at an interest rate of 2.91% on the original $25 price, which is locked in until 2020. The reset is usually the rate of the five-year Government of Canada bond, plus a premium of 2-3%, depending on the issue.

So here’s what happened with this preferred share. Investors saw that the reset was coming and it was going to be low. So they got out of it, driving the price down from $20 per share to $15, which drove the yield up. It sucks to be the guy who bought before, but this is just fine for someone buying now. Getting close to 5% isn’t bad.

But here’s what really makes that preferred share more attractive than the equivalent bond–the dividend tax credit.

Because dividends are taxed at a much lower rate than bonds, that 4.8% is worth about 6% in a bond. Which is a cool 2.3% more than the Fairfax bonds are paying right now. You’re getting paid a huge premium to hold the preferred shares over the bonds.

Why is that? One simple reason–investors are scared of interest rate risk. If rates spike up, the Fairfax preferred share will go down even further because new debt will enter the market which offers a more compelling interest rate. Suddenly, 4.8% on a preferred share won’t look so good anymore. If 6% becomes the new norm for preferred shares, suddenly the Fairfax issue trades at $12, and you’re looking at a 20% haircut.

So there is risk, but there are ways to mitigate it. If you’re reinvesting your dividends into more preferreds, then you’ll be constantly dollar cost averaging into better yields. You can also find preferreds that are likely to be repurchased when they come due, which will likely offer less in yield. Finally, you could take your new capital and use it to buy beaten-up preferreds.

Or, you could do nothing and just collect your equivalent of 6%. Unless you think rates are going to spike soon, it’s not a bad option, even if central banks hike one or two more times.

The point is this. Preferred shares mixed with a dash of smart tax planning can be a smart move for your portfolio. Even if you just buy an ETF, I think you need exposure to the sector.

Tell everyone, yo!