Home » Bear Case Scenario » Split Corps Conundrum Will Investors Suffer $XIC, Canadian Money Saver Explains It.

Split Corps Conundrum Will Investors Suffer $XIC, Canadian Money Saver Explains It.

Guest Post from Canadian Money Saver. A rather unique financial publication that many investors find valuable. Ignore their advice at your peril. Links at the end.

Split Corps: Worth the time?

Once in a while investors seem to come across a structured product that seems to answer a concern or meet a certain need. These products tend to be exactly what an investor is looking for at the time, which is why it was ‘structured’ in the first place. Often times, these products can be too good to be true and are making the issuer, broker and bankers more money than the investor. The most common product that we come across seems to be split share or split corp. investments. These types of holdings have some benefits but can also have aspects that investors need to look out for. Before investing in these types of structures, an investor will want to make sure they know what they are getting into and if it fits into their portfolio.

In general terms, split corps are a share structure that involve a preferred share and a capital share. As one would expect, the preferred share pays dividends to the holders while owners of the capital shares enjoy the capital gains. Due to the structure, holders can gain enhanced exposure to capital gains or dividends. Running through a quick example, let’s assume Split Corp X is selling a $10 preferred share and $20 capital share. They plan to split the gains and dividends for Company Y, which is priced at $30 and pays a dividend of $1 (3.3% yield). Split Corp X will take the proceeds ($20 + $10) and purchase Company Y at $30. Holders of the capital share now have exposure to the capital gains of a $30 company for only $20. On the other hand, holders of the $10 preferred share receive a $1 dividend, amounting to a yield of 10% compared to 3.1% if Company Y were purchased outright. To make a long story short, these structures are essentially a clever way to employ leverage. Admittedly, this is a simplified example and there can be various terms in the product that allow it to omit dividends.

The most important aspect of deciding if this type of investment is right for an investor is first determining if you understand what it really is. In our personal experience, we have found that attempting to understand the total fees on these products as well as the red tape that determines if and when dividends are paid can be time-consuming and downright confusing. While an investor should always understand the investments they hold, split corps. require an investor to wade through all of the regulatory documents in order to figure out the rules around dividend payments and what exactly you are paying in fees.

Another issue to examine is if these investments are even necessary in the portfolio. The main benefit of this type of security is an ability to gain tax effective returns. If an investor does not want dividends, they can purchase the capital gain (sometimes these shares still pay a dividend) share and if their tax situation is adverse toward capital gains, they can purchase the preferred security. While this would be a welcome feature to some investors, it is likely that the benefits are minimal to most. Since these structures often hold the ‘standard’ blue-chip type of companies, owning a split corp. may also be doubling up on other securities held in a portfolio. Finally, an investor needs to understand that they are giving up a benefit of holding the common shares (capital gains AND dividends) by choosing either the capital gain or preferred share. Some may be comfortable with this trade-off but the pros and cons should be understood.

There are some ways to enhance yields or provide for more tax effective returns for experienced investors. The simplest way, for those only wanting capital gains is to simply hold investments that do not pay a dividend for that portion of a portfolio. Further, if taxes are the concern, one could place the security in a tax-free or tax-deferred account to avoid any major tax consequences. Consequently, split corps held in tax sheltered accounts may want to be re-examined as it eliminates what is arguably the main benefit of these holdings while taking up contribution space for a less tax effective holding. For investors looking for the enhanced yield aspect of split corps, one could simply purchase the basket of stocks that the split corp. holds and write covered call options against the basket (or a portion of the basket). This allows an investor to keep capital gain potential and the dividend along with extra income from the call options. As always, investors should ensure they understand all of the risks with strategies such as this and do their own thorough due-diligence before pursuing such a strategy.

It is normal and understandable for losses to be incurred throughout ones investment journey. Truthfully, losses are and will be unavoidable. What is avoidable, however, are losses due to buying or being sold a security that one does not fully understand or a security that does not quite provide what is expected/needed. Many aspects of investing are out of an individuals’ control so when there is an opportunity that can or could have made ones financial situation better, everything in that investors power should be done to take advantage of it. This is especially the case when dealing with ‘non-standard’ investment products where understanding the product can help to manage an investors expectations and lead to a decision that improves ones financial situation. Many are familiar with the popular quote “Knowledge is Power” but it seems that knowledge is also money.

Ryan Modesto,

Canadian MoneySaver has been offering independent, personal finance advice since 1981. The MoneySaver publication, along with its sister company 5i Research, aim to educate and enlighten readers on all things finance and make the road to retirement a little less bumpy.

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http://www.CanadianMoneysSaver.ca

 

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