Beware the risk at stake with a high-yield return
Financial guru warns against possibility of losing principal in a closed-end investment
In a world of low interest rates, savers are on a constant hunt for something more.
But there’s a fine line between a safer, better return and one that carries too much risk.
For example, you can safely triple your return on a basic bank account this week by choosing Oaken Financial or Luminus Financial. Both are covered by deposit insurance and both are paying 1.75 per cent on a savings account — the best rates I could find. By comparison, my bank is offering 0.55 per cent for a similar account.
You can more than double that return by investing in the shares of Canada’s largest companies. These are the places where you shop, such as Loblaws, Metro and Canadian Tire, or where you buy phone services, such as BCE and Telus.
The same major banks that are paying less-than-inflation interest on your savings all raised their dividends this year. The average yield on Big Five common shares is 4.2 per cent.
But when you go from a 4-per-cent return to 6 or 8 per cent, you’re going through another door, as one reader discovered.
W.H. paid $10 a unit to buy into the Brookfield High Yield Strategic Income Fund in 2012. It is a closedend fund that invests in Canadian and U.S. company bonds that pay high rates of interest.
Brookfield pays a 65-cent annual distribution, so based on the $10 issue price, the yield would be 6.5 per cent.
“Our adviser recommended it as a safe fixed-income investment,” W.H. says.
The fund’s structure is complicated. It uses derivatives-driven strategies to reduce taxes by distributing the money as capital gains rather than the interest you’d normally earn from a fixed-income investment.
In his final budget as finance minister in 2013, Jim Flaherty clamped down on these funds by increasing the amount of tax that must be paid.
The Brookfield fund is due to wind up next July and people who own it would normally expect to have been paid the distributions and get their money back.
But four years later, the fund is worth $7.41 a unit, a decline of 26 per cent.
The fund has not been able to generate the money it needs to pay the distribution, so to make up the difference it has been returning money to unitholders. As it does so, the unit price falls because the fund is smaller, so each unit is worth less.
“We would have been much further ahead putting the money under the mattress, taking out quarterly payments and paying no fees,” W.H. says.
Brookfield says it can’t comment on how a financial adviser marketed the fund. Alice Olive, a marketing vice-president with Brookfield in Chicago, said in an email that it invests in companies that have better performance and default records.
But she says there are inherent risks investing in a closed-end fund, including the possibility of loss of principal.
Olive said Brookfield’s strategy is sound, but 2015 was a tough year for high-yield securities, particularly in the energy and commodities sector. She says the market for high-yield corporate bonds has improved, and through July 25 the fund’s value has risen.
Dan Hallett, a partner in Oakville’s Highview Financial Group, says the fees associated with this fund are high. It was sold as an initial public offering at $10 a unit, but before it landed on the TSX, fees of 52.5 cents a unit were paid out to the brokerage firms underwriting the issue. There were other fees as well.
“In other words, investors who bought this as an IPO were sitting with a fund worth $9.41 when it started trading,” Hallett says.
Brookfield charges a hefty 3.33per-cent annual fee to manage the fund.
Hallett says the fund was initially able to support its payout, but the distribution was set at such a high level, it didn’t allow for bad years. So when oil prices collapsed, the fund was hurt, as Olive noted.
Hallett figures with the lower asset value, Brookfield needs to generate a12-per-cent annual return to pay its fees, keep distributions flowing at the same rate and stop the unit price from falling further. He thinks that is unlikely.
The lesson here is that the lure of high yields in a low-rate world is hard for many people to resist, but they may not fully consider the risks. As well, the more complex the investment, the more it usually costs. Finally, think twice about an investment that’s based on a tax advantage. The Canada Revenue Agency doesn’t like them, and rules change accordingly.
“We should have been more careful,” W.H. admits.
If an investment seems too good to be true, it probably is. If somebody is offering you 6 or 8 per cent in a 2-per-cent world, ask yourself why. Adam Mayers writes about investing and personal finance on Tuesdays and Thursdays. Have a question? Reach him at amayers@thestar.ca.