As investors’ appetites grow for income-generating products, split-share issuers have responded with a new group of offerings.

With these products, holders of capital shares are paid a slice of the income derived from a basket of underlying common shares, while the rest is used to pay the holders of the preferred shares.

This is a change from traditional split-share issues, in which capital shareholders are entitled only to the capital gains produced by the underlying portfolio of common stocks. In traditional issues, preferred shareholders receive all the income from the dividend stream produced by the portfolio.

In the recent evolution, capital shareholders are paid part of the income, as well as any capital gains earned by the investment on maturity.

“The objective is to generate income for the capital shares, as opposed to just
generating capital appreciation,” says Brian McChesney, a managing director in the investment banking group at Scotia Capital Inc. in Toronto.

An example of this type is a planned offering by Brompton Split Banc Corp. Proceeds will be used to buy shares of Big Six banks. The idea is to generate sufficient income to pay 5.2% on the $10 preferred share and 8% on the $15 capital share.

A key attraction to split-share issues in general is the leverage built into the products, says McChesney.

Typically, leverage is 2:1 and is the result of the way the products are structured.
Assume a dealer buys common shares for a total of $100, and creates a $50 preferred share and a $50 capital share. The preferred share is entitled to dividends from the full $100 portfolio; owners of the $50 capital shares would receive the capital gains produced by the full portfolio. The degree of leverage varies among issues.

McChesney notes that the leverage is low-cost and non-recourse, meaning it remains outstanding regardless of what happens to the underlying stock. That’s different from what happens if money is borrowed to buy shares by way of a bank loan or a margin loan, and the shares subsequently drop in value. In those situations, the loans would be called and some of the shares may have to be sold to keep the lender onside.

“Equities go up and down, and the last thing you want to do is sell them when they go down. But with a split share, the preferred shares stay outstanding and you don’t have to sell any stock,” says McChesney.

But as the old saying goes, leverage cuts both ways. “If the performance is bad, you will get whacked,” says McChesney.

Greg Guichon, senior portfolio manager with Rockwater Asset Management Inc. in
Toronto, says that split shares are attractive “provided you like the underlying investment.” And he cautions that some split-share offerings may suffer from a lack of liquidity.

Split-share offerings have been part of the scene for about 20 years. Initially, they tended to be done on a single issue. Thus, the offering was structured in such a way that the yield paid on the preferred shares is higher than what the issuer would have to pay if it issued preferred shares in its own name. Such types of offerings remain popular:
recent offerings involve common shares of TD Bank Financial Group and Bank of Nova Scotia.

Later, split shares were done on a group of similar issues: outstanding deals include split shares on the Big Six Canadian banks, known as AllBanc Split Corp. ; another, Lifeco Split Corporation Inc. , was done on the publicly listed life insurance companies.

Later still, split-shares offerings were done on major market indices, such as the now-defunct TSX 35 index and the very much alive S&P 500 and S&P 100 indices.

Woven into most split-share issues is covered call writing — an option strategy whereby the manager sells call options on the underlying stocks it owns, collects the premium, but risks losing ownership of the shares.

In the case of capital shares, performance depends directly on how the underlying common shares fare. Capital shares can be “a bad thing, if the stock doesn’t perform,” McChesney says.

Here’s a taste of how some issues have performed:

> Lifeco split corp. inc. , a closed-end fund that invests in common shares of publicly listed life insurance companies, has been around since August 2000. Over the five-year period ended Sept. 30, 2005, the capital shares posted an annual average gain of 15.7%, which contrasts with a gain of 2.9% for the S&P/TSX composite index.

@page_break@> Brompton equity split corp. , a closed-end fund that invests in common shares of companies with market caps of at least $500 million, has underperformed the market benchmark.

From its April 2004 inception to Sept. 30, 2005, the fund posted an annual average gain of 19.1%, or more than five percentage points below the 24.9% gain for the S&P/TSX index.

> 5banc split inc. has been stellar. It invests in common shares of the Big Five chartered banks. From Dec. 31, 2001, to Sept. 30, 2005, the capital shares gained — in annual average terms — 19.3%, or more than seven percentage points above the 12.1% for the S&P/TSX composite index over the same period.

> Snp split corp. , a closed-end fund that owns a portfolio of companies included in the U.S. S&P 100 index, has underperformed considerably. From its inception in June 2001 to Sept. 30, 2005, it has posted an annual average loss of 19.8%, which is far worse than the loss of 0.73% for the S&P 100 index.

McChesney, who has brought 15 such deals to the market, says there are three key elements to a successful split-share offering: the underlying company must be large
and liquid, it must pay a dividend and it must have good growth prospects. IE