A case study in how not to invest in bank stocks – The Globe and Mail

I have two investments I just don’t understand: BK and BK.PR.A. They were purchased by a financial adviser I have since parted ways with. I know they invest in bank stocks, but I can’t understand why BK in particular is doing so badly. I feel that these shares are a special type of investment that is more complicated than most.

More complicated than most? That’s an understatement. Your adviser shouldn’t have recommended a product you don’t understand. What’s more, as you’ll see, the adviser’s recommendation to buy BK and BK.PR.A together makes no sense from a financial standpoint – except for the fat commission he or she likely pocketed in the process.

BK and BK.PR.A are two different classes of shares issued by Canadian Banc Corp., an investment vehicle known as a “split share” corporation. Canadian Banc Corp. holds a portfolio of the six biggest Canadian bank stocks, and while BK and BK.PR.A both provide exposure to those underlying stocks, they do so in different ways and with dramatically different results.

BK.PR.A, the preferred shares, are relatively stable. They don’t participate in the ups and downs of the underlying banks, but they pay a fairly secure dividend that is funded by the dividends from those shares. The preferreds also get first claim on the capital of the underlying portfolio up to the preferred’s issue price of $10 a share.

Adding yet another layer of protection, although BK.PR.A’s dividend is variable because it is tied to the prime lending rate, BK.PR.A’s yield is never allowed to drop below 5 per cent, as calculated on the $10 issue price. (BK.PR.A has been trading slightly higher than $10 recently, so the yield based on the market price is currently a bit below 5 per cent.) Reflecting its conservative characteristics, BK.PR.A has produced steady returns over the years, and is a suitable choice for an income-seeking investor.

BK, the class A shares, are a different story. Essentially, the class A shares (also known as capital shares) are entitled to all of the value in Canadian Banc Corp.’s bank stock portfolio after the preferreds’ dividend and fixed capital requirements are satisfied. This means the class A shares are effectively a leveraged bet on the underlying stocks. If bank stocks rise, the class A shares will rise even more. If bank stocks fall, the class A shares will suffer an even bigger loss.

The sell-off triggered by the novel coronavirus pandemic is a great illustration. From Feb. 21 through May 28, BK shares plunged about 37 per cent. That’s far worse than the drop of about 22 per cent for the BMO Equal Weight Banks Index ETF (ZEB), a fund that holds the same six banks – but with no leverage, and lower costs.

BK also pays a dividend, but it’s anything but stable. The dividend is reset monthly to yield 10 per cent based on BK’s average market price over a designated three-day period, which means the dollar amount of the dividend will rise in good times, and fall in bad times.

When markets get really ugly, however, BK’s dividend can disappear altogether. Even though none of the underlying banks has cut its dividend, BK suspended its payout in March after the net asset value per unit of Canadian Banc Corp. fell below the threshold of $15 that triggers a cessation of dividends on the class A shares. BK has since reinstated its dividend, but the monthly amount is about 40 per cent lower than it was a year ago.

You may be wondering how BK can pay a 10-per-cent dividend when the preferred shares are already yielding 5 per cent. According to the prospectus, “to supplement the dividends received on the portfolio and to reduce risk, the company will from time to time write covered call options in respect of some or all of the common shares in the portfolio.”

But many split share corporations also resort to selling stocks in the underlying portfolio to generate cash required to pay dividends on their class A shares, said James Hymas, president of Hymas Investment Management. “It is my belief that, if people understood class A split shares, they wouldn’t buy them.”

With the rebound in bank stocks this week, BK has recovered some of its hefty losses. But its total return, including dividends, for the five years through May 27 was still negative 1.2 per cent on annualized basis, according to Bloomberg. Over the same period, ZEB posted a positive annualized total return of 4.6 per cent. Clearly, an investor who wanted exposure to bank stocks would have been better off buying a low-cost bank ETF instead of a leveraged product such as BK.

What’s more, your adviser should have known that, although BK and BK.PR.A have different characteristics on their own, they are complementary pieces of the same underlying portfolio. When you put them together you’re essentially buying a portfolio of bank stocks – just in two different wrappers that add unnecessary layers of complexity and fees. Canadian Banc Corp.’s management expense ratio of 1.35 per cent is more than double ZEB’s MER of 0.62 per cent.

“Your reader was given really stupid advice by the adviser, because when you own the class A shares and preferred shares in equal proportions, all you own is a fund with a lot of bells and whistles that owns bank stocks,” Mr. Hymas said. “You can do that a whole lot easier by buying an ETF that owns bank stocks. And it’s much cheaper.”

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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