What does moving up the Capital Stack mean?
I recently retired and was counting on living off of my investment portfolio, but quite a number of my portfolio names were either taken over by acquisition or redeemed by the issuer. In case you don't know what that means, it just means that a lot of my investments that I was counting on for income has suddenly become, or will soon become, just a pile of cash. So when people ask me how I plan to rebuild my income portfolio and I use the industry jargon by saying that I am moving up on the Capital Stack, then I often get a bunch of blank stares. What does this mean? What is a Capital Stack?
The simplest explanation is to describe what happens if a company goes bankrupt and the courts handling the bankruptcy liquidates the company and gets a pile of cash, who is it that they pay back first and what order is everybody else getting paid? This is the capital stack.
1st to get paid back are creditors. If you sold raw materials to the bankrupt company, you get paid first.
2nd to get paid back are the banks. The banks that gave the company a line of credit or some other short term loan to make payroll or buy supplies, they are the second to get paid back.
3rd to get paid back are bondholders. There are both secured and unsecured bondholders, the secured bondholders get paid first and then the unsecured. A bondholder is basically someone who loaned the company money on a long term basis so that they can either start up or expand or whatever.
4th to get paid back are preferred shareholders. A preferred share is a contractual obligation that the company made to pay dividends and return the principal to someone who bought the preferred shares. There are many types, some pay a fixed dividend, some pay a variable dividend based upon prevailing interest rates and some are called rate reset, which would pay a fixed rate for 5 years usually and then would reset the dividend based upon prevailing interest rates.
Last to get paid back are common shareholders. This is everybody who owns an equity stake in the company as opposed to loaning the company money. Whether the common shareholders get paid a dividend and how much they get paid is dependent upon the decisions made by the Board of Directors. They generally meet each quarter to decide if the common shareholders get paid and how much.
So, when I tell people that I am moving up the capital stack, it means that I have been busy buying, for examples:
MIC.PR.A: Preferred shares issued by mortgage insurance company Sagen, a fixed rate preferred share. Why this? Because Canada's past 3 months show negative jobs growth, so despite an inflation rate of 3.1% (above the Bank of Canada's target of 2%), I think the Bank of Canada might have one more interest rate hike and then they're probably done.
BCE.PR.A: Preferred shares issued by the telecommunication company Bell Canada, a 5 year rate reset preferred which will reset their dividend rate in around August 2027. I was buying this after the interest rate hike but before the latest jobs figure because I decided that I had to hedge my bet just in case the Bank of Canada does actually raise interest rates a lot more.
GWO.PR.R: Preferred shares issued by the life insurance company Great West Life, a fixed rate preferred. I actually bought it before the most recent interest rate hike, but the same opinion as above.
And I have also been adding to some preferred share ETFs, specifically including, CPD from iShares, DIVS from Evolve.
For corporate bonds, I previously bought XCB from iShares before the most recent interest rate hike, so I am down a little bit on XCB. But if I am correct and the Bank of Canada might only have one more rate hike in them, then I will wait and let XCB take another small hit before loading up on more corporate bonds.
In the USA, the situation is somewhat different. The US inflation rate is even higher than in Canada, at 3.7% despite having the same 2% target. But the USA's jobs report showed a reasonable strong jobs growth and a decent GDP print, so I feel like the Federal Reserve may potentially have a lot more interest rate hikes to come. I currently already have some PSK, a Preferred Shares ETF from SPDR, but I feel like I will not be adding more until I see what happens with the US FED. The same goes for US corporate bonds, but I don't currently have any US corporate bonds. So I will continue to sit on TFLO from iShares while I wait to see what happens down south.
