Key role for pref shares despite losses – Absa

Tax changes and recent declines in preference share prices have put the spotlight on an equity security that until recently seemed firmly established as the South African investor’s favourite hybrid instrument.

But according to Absa Investments, tax and market changes simply clarify the pref share’s position as an option that works best for those who ride out interest-rate cycles rather than those looking for short-term solutions.

Craig Pheiffer, General Manager, Investments, at Absa Asset Management Private Clients, says in the long run the pref share’s role in well-diversified portfolios will be unaffected by concerns about tax changes and rising rates.

Pref shares have the attributes of both debt and equity. Dividends fluctuate in line with prime. Underlying prices soften as rates rise but firm as rates dip.

As rates fell this last two years prices rose. In 2010 pref shares delivered total returns of 13.6%.

Prime-linked perpetual preference shares are issued by various banks and many listed companies. Dividends are paid six monthly in arrears.

Bank issues are non-cumulative (holders are not entitled to any missed dividends) while corporate issues are cumulative (missed dividends accrue).

Pheiffer notes: “Dividends are currently tax-free, but tax applies from April 2012 when Secondary Tax on Companies (STC) is scrapped. When dividend tax comes in, issuers say they will pass STC savings to shareholders in the form of higher dividends, leaving an investor’s net position roughly the same.”

Tax questions are now clearer, but it is still important to develop better all-round understanding of pref shares, says Pheiffer.

Investors should note:

• This instrument can be considered more risky than pure money market investments as prices fluctuate
• As income-generating investments they may be less risky than pure equity
• Given capital volatility, pref shares should not be used as a short-term ‘parking bay’ for surplus cash
• As they are not growth investments, they may not suit those with a very long-term investment horizon

Pheiffer adds: “Pref shares retain their place in well-diversified portfolios. By mid-March this year pref shares had lost around 6% for the year as investors inexplicably shunned pref shares following the National Budget. However, prices recovered in March to leave the total return for prefs for the first quarter down just 1.4%

“Price fluctuations do not perturb those with the medium term in mind who hold their preference shares through rate cycles. For them, higher rates simply mean higher nominal dividends.

“The current situation underlines the lesson and clarifies the preference share’s vital role as a means of achieving added portfolio balance.”