Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

These High-Yield Investments Have Built-In Inflation Protection

Looking for a high-yield investment that is also designed to protect you from inflation over the long-term? If you're willing to look north and do some digging, a certain type of Canadian preferred share could be just what you're looking for.

Most preferred shares are fixed perpetuals -- they offer a fixed dividend rate and no maturity date. Since the rate is set forever, they may not hold their value when interest rates are rising. Floating rate preferred shares fix that problem, but they're generally pegged to short-term benchmarks at lower rates.

Enter "Rate Resets"

Rate resets are a made-in-Canada inflation-proof preferred share designed to give you the best of both worlds -- the higher yields of fixed perpetuals and the inflation-protection of a floating rate preferred. Rate resets were invented in March 2008 by Desjardins Securities, a subsidiary of Quebec-based Desjardins Group, North America's largest association of credit unions.

Investors love them for their flexibility, and almost all new Canadian preferred issues are rate resets. It also helps that their dividends are cumulative, meaning any missed dividends must be paid eventually and that dividends qualify for the lower dividend tax rate in Canada, which should be the same for the U.S.

How Rate Resetting Preferred Shares Work

Most rate resets have a fixed dividend rate for five years from the issue date. That dividend rate is pegged to the five-year Bank of Canada bond rate plus a spread. Some issuers offer higher spreads than others, depending, in part, on their credit rating.

At the end of five years, the issue is brought back to its par value (usually $25) and you are offered a new market rate.

You have a choice. For the next five years, you can peg your shares to the current five-year Bank of Canada bond rate plus the original spread or to the three-month Canadian treasury-bill rate plus the same spread. The five-year bond rate offers a higher yield, but the three-month rate (which is reset quarterly) affords more protection if rates are rising rapidly.

At the end of each five-year term, the issuer also has the option to redeem the shares at par. That protects the company from paying above-average interest rates if the spread is high.

The High-Yielding, Preferred Share Advantage

In September 2011, the common shares of Toronto-based global property insurer Fairfax Financial (TSE: FFH) traded with a dividend yield around 2.5%. But at the same time, their series C preferred shares (TSX: FFH-PC) paid C$1.4375 a share annually, equating to a 5.6% yield (C$1.4375/C$25.66). The shares were rated Pfd-3 by Canada's Dominion Bond Rating Service (DBRS), which equates to a solid "BBB" from Standard & Poor's, meaning the dividend should be safe.

#-ad_banner_2-#Not only could you more than double your yield with the preferred shares, you could also inflation-proof your income if interest rates ratchet up. Come December 31, 2014, the rate resets to the five-year Canada bond plus 315 basis points (3.15%). The five-year bond rate has averaged around 1.4% over the past few months, so that would give you about a 4.6% yield at today's rates and more as bond rates rise.

These preferreds are callable, so if rates are substantially higher, Fairfax may decide to exercise its option to redeem the shares at $25 apiece.

In that case, your yield to the first call date would be about 4.9% at today's purchase price. Even if the shares are called, you would get a solid yield of close to 5%, indicating they are attractively valued at today's price.

[Click here to use InvestingAnswers' Yield to Call Calculator]

Some Points to Consider Before Diving In

Please note that if you buy shares trading well above par and they are called away, your yield over the holding period will average out to only about 2%-3% a year, after factoring in your $2-$3 capital loss at redemption. So you need to be selective. You can find a list of Canadian rate resets on prefInfo.com.

All these shares pay dividends in Canadian dollars, so payments to U.S. investors can go up and down with the CAD-to-USD exchange rate. Also, dividends are subject to a 15% foreign withholding tax for U.S. investors, but the tax can be reclaimed if held in a taxable brokerage account.

Where to Start Trading

The shares trade on Canada's Toronto Stock Exchange (TSX), which you can access directly through most brokerage services, either online or with a phone call. Like many preferred shares, they trade in low volumes and could have a large bid-ask spread. As such, you may want to buy shares in small lots of under a 1,000 at a time and set at least a mental price limit that's close to the current selling price.

The Investing Answer: The investing ideas I present here provide a good starting point for further research. You should also the fundamental characteristics of every potential investment opportunity. In addition, assess how well a particular stock/fund matches your investment needs. And do your own due diligence on a security to decide if it is right for your portfolio.

Editor's note: In the October 2011 issue of High-Yield Investing, Carla gave her subscribers the names of five rate reset securities with yield over 6%. To learn more about her newsletter devoted exclusively to securities with abnormally high dividend yields, click here