DGS.PR.A : DBRS Downgrades to Pfd-3(low)

DBRS has announced that it:

downgraded its rating on the Preferred Shares issued by Dividend Growth Split Corp. (the Company) to Pfd-3 (low) from Pfd-3. The Preferred Shares have experienced a considerable drop in downside protection (to 31.5% in June 2023 from 38.9% in May 2022) as a result of the decline in the portfolio’s net asset value (NAV) in response to the volatility in the stock market, which was triggered by the mix of the global high inflationary environment, tighter monetary policies, and various geopolitical events, such as the Russia-Ukraine war. The Company’s maturity date is September 27, 2024. The board of directors may extend the term of the Company and the shares by successive terms of up to five years, provided that shareholders are given an optional retraction right at the end of each successive term.

The Company invests in a portfolio consisting primarily of equity securities of Canadian dividend growth companies. In addition, the Company may hold up to 20% of the total assets of the portfolio directly in global dividend growth companies or indirectly through exchange-traded funds for diversification and improved return potential. To qualify for inclusion in the portfolio, at the time of investment and at the time of each periodic reconstitution and/or rebalancing, each dividend growth company included directly in the portfolio must (1) have a market capitalization of at least $2.0 billion and (2) have a history of dividend growth. Investments will generally be equal weighted at the time of investment; however, after rebalancing the portfolio, the Company may hold nonequal weight positions.

Dividends received from the portfolio are used to pay fixed cumulative quarterly dividends equal to $0.55 per annum (p.a.) to each Preferred Shareholder, yielding 5.5% on the original issue price of $10.00. Holders of Class A Shares receive monthly distributions targeted at $1.20 p.a. The NAV test in place prevents any distributions to the Class A Shares if the Company’s NAV falls below 1.5 times (x) the principal amount of the outstanding Preferred Shares. Distributions to the Class A Shares are currently suspended.

As of June 8, 2023, the downside protection stood at 31.5%, compared with 38.9% as on May 30, 2022. Dividend coverage based on the current dividend yield on the portfolio was 0.6x. Without giving consideration to the capital appreciation potential or any source of income other than the dividends earned by the portfolio, the targeted monthly distributions to the Class A Shares are likely to create a grind on the portfolio’s NAV equivalent to 1.4% over the remaining term to maturity. The Company can write covered call options for some or all of the portfolio’s common shares to generate additional income to supplement the dividends received on the portfolio. The Company can engage in securities lending.

Considering the amount of downside protection, the term extension, and the projected grind on the portfolio, DBRS Morningstar downgraded the rating on the Preferred Shares to Pfd-3 (low) from Pfd-3.

The main constraints to the rating are as follows:

(1) The downside protection available to holders of the Preferred Shares depends on the value and dividend policies of the securities in the portfolio. In current times, valuation is exposed to market fluctuations resulting from high inflation, economic slowdown, global supply chain disruptions, and the Russia-Ukraine war.

(2) Volatility of price and changes in the dividend policies of the underlying issuers may result in significant reductions in the Preferred Shares’ dividend coverage or downside protection from time to time.

(3) Dividends and interest received on the portfolio are currently unable to fully cover distributions on the Preferred Shares.

(4) The Company relies on the portfolio manager to generate additional income, through option writing, to meet distributions and other trust expenses without having to liquidate the portfolio’s securities.

(5) Stated monthly distributions on the Class A Shares will likely create a grind on the portfolio. This risk is mitigated by an asset coverage test of 1.5x that ensures sufficient levels of downside protection to the holders of the Preferred Shares.

DGS.PR.A has a Whole Unit NAVPU of 14.75 as of 2023-6-15. It’s a big issue, with over 48-million Whole Units (preferred share + Capital Unit) outstanding as of 2023-6-21.

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