Looking for yield; Beware of return of capital

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This low interest rate environment has encourage the investment industry to invent investment products that have yields that seem too good to be true. A warning bell should go off when you see a yield of more than 7 per cent. Some investors are so blinded by yield that they ignore everything else, even their own better judgement.

As a retiree, I understand the need for steady monthly income but it pays to be skeptical. It is important to read the fine print on how the income is being generated. I recently did some research on iShares Canadian Financial Monthly Income ETF. (Trades on the Toronto stock exchange ticker FIE)

According to FIE’s website, the ETF’s investment objective is to “maximize total return and to provide a stable stream of monthly cash distributions.” The ETF’s list of holdings includes Canadian banks, insurers, asset managers and real estate investment trusts, plus exposure to preferred shares and corporate bonds through two other iShares ETFs. The fund’s “distribution yield,” as of Nov.  7 was 7.17 per cent.

Right away, a yellow flag should go up. Canadian banks and insurance companies generally yield between 3 per cent and 4 per cent, and the REITs and preferred shares in the fund yield, on average, about 5 per cent to 6 per cent. How is the fund able to distribute more than 7 per cent?

You won’t find the answer on the ETF’s main web page. You have to click through to a PDF of the prospectus where, on page 46, you’ll find the following:

“If FIE’s net income and net realized capital gains in a year are insufficient to fund the regular distributions [of 4 cents a month or 48 cents annually], the balance of the regular distributions will constitute a return of capital to unitholders.”

Return of capital, or ROC, is the portion of a distribution that doesn’t consist of dividends, interest or capital gains triggered by the sale of securities. In FIE’s case, ROC represents a huge part of the fund’s distribution – about 35 per cent in 2015, 52 per cent in 2014 and 66 per cent in 2013. Again, you have to dig for this information, which can be found under the “distributions” tab using the “calendar year” and “table” views.

Now we know how FIE is generating that juicy yield of more than 7 per cent: it’s giving back a portion of unitholders’ capital in the fund. This is cash that would otherwise remain invested in the fund’s securities to grow and generate more income.  

How do you suppose all of those hefty ROC distributions have affected FIE’s unit price over the years? Well, on the fund’s inception date of April 16, 2010, FIE closed at $7.10. Six and half  years later – the units closed at $6.74. So, an investor who held the units since the beginning would have collected the monthly distribution but taken a loss on the unit price.

The lesson here is that ROC is not a free lunch. In exchange for getting a higher yield now, investors sacrifice some or all the unit price appreciation over the long run. The problem is that many investors don’t take the time to understand where their distributions are coming from. If you own a fund whose yield seems too good to be true, chances are you are paying for that yield out of your own capital without even realizing it.

Skill-testing question: If a Canadian investor were to sell the units today would it be a capital gain or loss? Answer: he or she would still likely have to report a capital gain. That’s because ROC distributions are not taxed immediately but are subtracted from the adjusted cost base of an investment for the purposes of calculating capital gains or losses.

Keep in mind that return of capital isn’t necessarily a bad thing. There are cases, for example, in real estate that return of capital comes from tax savings from depreciation of some new properties.

 

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