My Portfolio Asset Allocation – Part 3 (ZPR)

This is a multi-part series exploring in-depth each of the individual allocations I have in my B&D investment portfolio.

In today’s post, I’ll dig into ZPR which is the stock ticker symbol for the BMO Laddered Preferred Share Index ETF. I’ll talk about:

  • what it is
  • the actual allocation in the portfolio
  • why I hold this in my B&D portfolio
  • fees/costs to hold it
  • the income it pays me
  • its growth potential
  • which investment vehicles (TFSA, RRSP, LIRA, non-registered account) I put this ETF in
  • Alternative ETF(s) for tax loss harvesting purposes
  • the future of it in my B&D portfolio

Information provided is considered accurate and up to date at the time this post was published.

What is it?

ZPR is a rate-reset preferred share ETF that is managed by BMO GAM (Please note I have no affiliation whatsoever to them, I just hold it as part of my portfolio. I just chose this one to invest in it). They define it as follows in their Fact Sheet and on their website:

The BMO Laddered Preferred Share Index ETF (ZPR) has been designed to replicate, to the extent possible, the performance of the Solactive Laddered Canadian Preferred Share Index, net of expenses. The Fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index.

The Solactive Laddered Canadian Preferred Share Index includes Canadian preferred shares that meet size, liquidity, listing and quality criteria. The Index uses a five year laddered structure where annual buckets are equal weighted while constituent securities within each bucket are market capitalization weighted.

Sometimes, the way the ETF definition provided by the ETF provider can be in plain and simple language and sometimes it isn’t and sometimes it isn’t complete. In this case, I went looking around and I found something from Horizon ETFs that at least, for me. felt a bit easier to digest (though not short and sweet). It also explains the full spectrum of preferred shares types out there and not just rate-reset preferred shares. As well, because preferred shares and preferred share ETFs are so poorly understood by the general public, I thought it would be a good thing to provide some further context.

A preferred share is a hybrid security that offers both stock and bond-like features; it provides fixed payments (like a bond) in the form of dividends, but has a share price (like a stock) that has the opportunity to rise or fall. This is why a preferred share is often considered or referred to as a “bond without a maturity date.”

In a company’s capital structure, preferred shares rank above common shares and just behind unsecured debt, which means in the event of an issuer’s bankruptcy, preferred shareholders would have a greater claim on assets than common shareholders, but a lesser claim than bond holders. Like other fixed-income securities, preferred shares are also subject to credit risk, with independent credit rating agencies assigning various levels of credit risk to issuers.

Types of Preferred Shares

Preferred shares can be structured in many ways to offer different benefits and features. Below are the four types of preferred shares:

1. Perpetual Preferreds: This type of preferred share has no maturity date and pays a fixed dividend upon issue, usually declared and paid quarterly, as long as it remains outstanding. Shareholders of perpetuals do not have voting rights and the issuers of perpetual preferred stock can typically redeem the shares.

If a perpetual preferred share is retractable, this means that the issuer can retract, or call back, the shares and decide to provide the shareholder with the issue’s value at par, payable in cash or the equivalent value in common stock. Par value refers to the predetermined face value for the redemption at the time of the original issue.

2. Floating Rate Preferreds: Sometimes referred to as a “variable rate” preferred share, this type of issue pays dividends quarterly or monthly with a rate that fluctuates, or “floats”, with a market interest rate such as a major bank’s prime rate. These types of preferreds also set a minimum dividend or “floor.” These issues typically have a set term and par value, which is repayable in cash at maturity.

If the floating rate preferred share is retractable, this means the issuer can recall the issue at any time prior to maturity in exchange for cash or equal value of the common stock. Some floating rate preferred shares can also be perpetual with no set term.

3. Convertible Preferreds: Similar to a convertible bond, a convertible preferred gives the investor the option to convert his or her holdings into some other class of shares at a fixed price on a specified date or within a specified period. Normally, the option allows for converting preferreds into the issuer’s common shares.

An investor generally pays a premium for this type of option due to the conversion terms influencing a convertible preferred’s share price, which is why a convertible preferred share will be typically priced somewhat higher than an equivalent fixed perpetual.

4. Rate-Reset Preferreds: A rate-reset preferred share offers a fixed dividend payment where the rate of that payment is reset upon a specific date, typically every five years. Generally, the rate will be a pre-determined spread above a government bond with a similar term. In Canada this is usually a five-year Government of Canada bond.

Once a rate-reset issue comes to term, the shareholder will generally have two options — hold for a new five-year fixed rate period or convert the shares to a floating rate security.

Currently, rate-resets are by far the most popular investment structure in the Canadian preferred share market, accounting for more than 60% of all available preferred shares listed in Canada.

On a risk scale, BMO GAM puts ZPR in the medium level of risk. Considering that preferred shares are something between a bond and a common stock, as well as the type of price swings it can have, that makes sense to me. 

Also, with the interest rate reseting every 5 years, when rates rise, the value “should” go up. And when rates drop, it “should” down in value. I say “should” because this type of ETF at times can fluctuate heavily and can sometimes scare investors. I’ll talk more on that when I discuss the future of this ETF later in this blog post.

Lastly, you’ll possibly hear from others out there that they don’t consider a rate reset preferred share ETF like ZPR to be a fixed income component in a B&D portfolio. The reason being that it fluctuates more like an equity than a bond. I understand their point of view however I still consider it to be part of the fixed income component of my B&D portfolio.

 

THE PORTFOLIO ALLOCATION

Why Hold it in my b&D portfolio?

I’ve held ZPR continuously since I rebalanced my portfolio March 30, 2020 (Prior to that, the fixed income component of my portfolio consisted fully of the ETF VAB). Interest rates were at a low point when Central Banks dropped their rates to counter the effects of Covid. In my mind, interest rates could not go lower. As a result, I sold almost all of VAB and bought ZPR and VSB. This was a successful move. It wasn’t that interest rates were going up right away. It was the anticipation that they would. 

Including the dividends paid out on ZPR since buying it March 30, 2020 to the end of that year, ZPR returned 38.85% without counting any additional purchases made later in the year when I had more cash to invest. Those later purchases returned less as the price to buy ZPR rose. 

In 2021, it was 23.42%.

For 2022, the story is a bit different. Up to June 24, 2022, it’s been -8.72%.

Why?

It could be a multitude of things. 

First, one of those things could be buy the rumour, sell the news. Up to 2022, central bankers had not increased interest rates. In 2022, they started increasing them. Interest rate increases were not longer speculation (rumour). They are now reality(news).

Second, it could once again be…anticipation. But a different one than 2020. People like to worry. And gamble. It’s why casinos and lotteries exist. Loser odds but people still gamble. Greed. Unlike 2020, this time it’s anticipation of a recession. 

Of course a recession is coming. It’s normal. And healthy. And in recessions, people anticipate interest rate decreases even while inflation is rampant and interest rates are increasing. When a recession happen, who knows. 

Anybody saying they know with 100% certainty when the next recession hits should also provide me with the winning numbers for the next lottery draw or point to the slot machine in the casino which will hit the jackpot on the next play. That’s why I have a disclaimer on my blog. Listen to the business news and within minutes of each other, they’re interviewing an investment “professional” saying buy while the next says sell. Nobody knows.

So, how do I manage this uncertainty?

By buying tons and tons of crypto!!! 

Sorry, I had to add that in because we all need some humour. Do. Not. Buy. Crypto!

Seriously though, I listen to and read business news and news in general. Being aware of what’s going on out there does help even if you sometimes get conflicting information. We all need to get good at tossing the chafe from the gold nuggets. If I didn’t try to do that, I’d be the equivalent of a deer in the headlights. Frozen. That’s not good.

The other thing I do is consider how my portfolio is doing overall. As indicated in Is Your Investment Portfolio Competitive, I compare my portfolio to others. And for now, I’m at the top of the pack. 

Lastly, I consider what I sold to buy ZPR. Back in 2020, that was the ETF VAB. VAB, including YTD interest payments for 2022 up to June 24, 2022, has a return of -12.76%. ZPR, including YTD dividend payments for 2022 up to June 24, 2022, has a return of -8.72%. For now, ZPR is doing better. If the spread between those two ETFs narrow further, I will consider my options. I also consider how VSB is doing, currently at -4.41% using the same evaluation parameters and how the spread between ZPR and VSB may widen.

I’ll admit that ZPR is currently the allocation that I’m assessing regularly in my B&D portfolio. Do you notice how much longer this blog post is compared to Part 1 and Part 2? However, with the various evaluation criteria I use, I know I at least have something in place to make future decisions with even if they aren’t set by pure logic.

the associated fees/costs

The one fee I always look at is the MER (management expense ratio) and the ETF provider, like Vanguard, has an obligation to provide what it is so investors understand the total cost of owning this type of investment. It’s defined as follows:

The management expense ratio (MER) is an annualized measure of the cost charged to investors, to invest in a fund. It is calculated by dividing the total of the expenses charged to manage and operate the fund by the total assets of the fund. The expenses include the management fee paid to the fund manager and operating expenses (taxes and administrative costs). The MER is calculated as a percentage of the total assets under management for the fund (AUM).

For ZPR, the MER comes in at 0.50%. Therefore, for every $1,000 invested, they charge me $5.00 annually. Compared to many index ETFs, this is a higher than average MER however the return since 2020 (even with the negative YTD return for 2022) has made this a worthwhile addition to my B&D portfolio. Versus a potential MER of 2%-3% on many mutual funds translating to $20-$30, $5.00 is a worthwhile cost.

income Received from this etf

ZPR pays out dividend income. That means for every dollar earned (assuming it’s in your non-registered account), you get a Canadian Dividend Tax Credit and reduce the amount of income tax owing. For context, as ZPR qualifies as an eligible dividend under the Canadian Dividend Tax Credit, you could end up paying no income tax whatsoever if your only income was from ZPR and was around $50,000. See here

That does change if the dividends from ZPR are tax sheltered or tax deferred. The investment vehicle (e.g.: TFSA, RRSP, LIRA, non-registered/cash/margin account) that houses the ETF will determine which tax situation applies.

Growth potential for this etf

From my personal experience, ZPR has been a medium growth ETF. It is though a situational allocation to the B&D portfolio and I’ll explain more below in the future of this ETF section.

Placement in Investment vehicles

I’m a Canadian with tax residency in Canada so investment vehicles and tax treatments are related to Canada. I currently have a TFSA, RRSP, LIRA, and a non-registered account which is also known by many as a cash account or a margin account

Legally minimizing and/or deferring the greatest amount of taxes possible is the primary criteria I use to decide which investment vehicle to house an ETF. Since I have a TFSA, RRSP, LIRA and a non-registered account, I use a 3 level filter which is below.

PRIMARY: TFSAs are for investments with the highest capital growth potential as it offers tax-free compounding and any withdrawals made are tax free as well. 

SECONDARY: The non-registered account takes up any of the surplus that doesn’t fit in the TFSA. Also, any investment income that has preferential tax treatment such as capital gains (as I write this, only 50% of capital gains are taxable) or is eligible for the Canadian Dividend Tax Credit should be going in this account.

TERTIARY: RRSPs/LIRAs take up any of the surplus that doesn’t fit in the TFSA and the non-registered account. Therefore, the lowest growth investments would be found here  as well as investments with the heaviest taxable income generated (in most cases, that would be bonds). The benefit of an RRSP/LIRA is that any income taxes owing are deferred until I decide to withdraw from them. The full amount withdrawn is taxable in the same way as employment income. Any taxes paid at withdrawal are based on whatever tax bracket I fall into for that particular calendar year. Therefore, compounding can occur tax free until then.

Based on the above criteria, in which investment vehicle(s) do I currently have ZPR? 

I actually hold this ETF in all my investment vehicles currently. Therefore, the TFSA, RRSP, LIRA, and the non-registered account. This may sound contrary in some ways however I personally believe to hold a fixed income component of the B&D portfolio for rebalancing purposes in all investment vehicles. That includes a 15% fixed income weighing specifically within the TFSA. Having the ability to rebalance is a fantastic tool in each of the investment vehicles. When markets take a dive (and they do), a small portion of fixed income can help calm the nerves as well as take advantage of a potentially profitable situation. 

tax loss harvesting strategy

Tax-loss selling (or tax-loss harvesting) occurs when you deliberately sell a security at a loss in order to offset capital gains in Canada. You can then use these losses to offset your taxable capital gains. This applies to the non-registered account only. The other investment vehicles (TFSA, RRSP, LIRA) are not eligible for this.

In Canada, the last day in a calendar year for tax-loss selling is typically the third to last business day of the year (not counting any statutory holidays that could happen between then and the end of the year). If you sold at a loss on or before that date, you’re able to deduct your loss against your gains in that calendar year. However, you can also carry your loss back for the previous three years to offset capital gains or carry it forward indefinitely to offset future capital gains.

Also, beware causing a wash sale. This can also be called the superficial loss rule. What this means is that if an investor buys back a security within 30 days of selling it, then they are not permitted to claim the capital loss for tax purposes. Failing to obey the 30-day rule will result in the capital loss being disallowed for tax loss harvesting. To avoid this, I would buy an ETF similar to the one sold but measured on a slightly different index. A wash sale can also occur if you sell in one investment vehicle (e.g.: your non-registered account) and buy that same ETF in another (e.g.: your TFSA) so be careful to not do that within the 30 day period.

As mentioned earlier, ZPR is an ETF that tracks the Solactive Laddered Canadian Preferred Share Index.

Therefore, I would consider CPD that is an ETF managed by iShares which tracks the S&P/TSX Preferred Share Index. It holds about 78% of it’s preferreds in the rate-reset category and is a fairly good proxy to ZPR.

Lastly, tax loss harvesting for ZPR only applies for the portion that I hold in my non-registered account. It’s not applicable for the portions I hold in the TFSA, RRSP and LIRA.

 

The future of this etf

I’d mentioned earlier that ZPR is the ETF that I’m assessing regularly within my B&D portfolio. There will come a time where I will swap out most, if not all, of  ZPR for what will likely be a bond ETF.  

The question is: When? Just as I swapped out VAB for ZPR and VSB at the end of March 2020, there will come a point to do a reversal. Right now, it’s feeling like it may be end of 2022 or early 2023. As more information becomes available, I may reassess this. 

Most people think that it’s the equities portion of a B&D portfolio that requires the most attention. What I’ve found since I started investing using a B&D approach is that it’s more so the fixed income component of the portfolio instead. 

For now, ZPR will stay put. Once I make a change regarding it, I shall publish it on this blog in short order.

Summary

So that’s my overview of the ETF ZPR that currently holds an allocation in my B&D portfolio. Please let me know what you think. Was the overview useful? Was anything missing? I’m happy to hear all feedback.

About the picture: I snapped this on June 28th, 2022 in the Basse-ville of old Quebec City. It’s an art installation part of the Passage Insolites public art circuit titled “When my father died it was like a whole library had burned down”. The artist is Susanna Hesselberg from Malmö, Sweden.

This was the most difficult of the art installations to find. Luckily, the AirBnB was just around the corner from this and I had already explored the area quite a bit. The description on the plaque beside it says “Scarcely visible on the horizon, a library plunges deep into the abyss of an underground shaft.” They also make the following reference “This buried library, not unlike a tomb,…”.

This art installation is the one that I enjoyed the most. It really did look like you were looking down a shaft into a tomb. You have to wonder how they had this shaft set up in the first place. The picture may not convey how deep it is however I will say, it was quite so. It becomes lost in the darkness below. I felt really lucky to get this picture of it while fluffy white clouds up in the sky reflected on the transparent cover. 

The things you can get to see and do when you’ve built a financial cushion that allows you to wait for clouds to position themselves just so.

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