Preference shares as an asset

As markets remain volatile around the world, South Africans should remain calm and rather view the current environment as a chance to consolidate and look at new opportunities. For investors seeking income, tax efficiency and low risk to capital during these changing times, the preference share market is an attractive option.

Preference shares are a specific category of equity in a company and are characterised by having a pre-determined dividend yield that is paid to the holder. They are typically higher ranking than ordinary shares, as they carry preferential rights to both capital and dividends.. As a result, they are considered low risk investments when compared to the ordinary shares of a company. For example, in the case of a liquidation, the preference shareholder is repaid their capital prior to any ordinary shareholder. Grindrod Bank Fund Manager, Gareth Stobie, states “Repayments are however usually limited to the nominal capital invested. Furthermore, preferential rights are generally expressed as a percentage of the par value.”

Why do companies issue preference shares? Stobie explains that preference shares are a useful form of capital. They are most commonly used to bring down the after-tax cost of funding, for example, when such funding is not used in the production of taxable income. For banks, listed or non-redeemable preference shares are a cost effective and efficient form of Tier 1 Capital,, while redeemable preference shares can be used to fund other preference share transactions. Corporates typically use preference shares in mergers and acquisitions and for balance sheet restructuring.

Types of preference shares

There are three types of preference shares, all of which provide unique benefits.

Redeemable preference shares offer capital guarantees and a defined exit mechanism. They have a finite maturity date and their yields are generally lower than listed preference shares due to improved security. In addition, they are issued by quality guarantors such as major banks and life houses. There is however, a specific period of time for which redeemable preference shareholders must hold a preference share.

Convertible preference shares can be converted to ordinary shares at a future point in time. Some examples of convertible preference shares in South Africa currently are Mvelaphanda, Angloplat and Clover. Stobie says, “The benefit of these shares is that if the ordinary share has performed well over the period that the investor has been holding the convertible preference share, it means that it will increase in value – you will get a pre-determined yield, but you will also be able to enjoy the fruits of the underlying ordinary share.”

Finally, listed preference shares are those listed on the JSE. They are sold at a price determined by the market. There is no undertaking by the issuer to repay the capital, hence they are commonly known as non-redeemable. The advantage of these would be that the dividend yield is generally higher than a redeemable preference share, but your ability to exit the investment is limited – you have to sell it in the open market to a third party and you are therefore vulnerable to market risk. However, this market movement could actually be up or down. The prices they are trading at currently are particularly attractive.

Benefits of investing in preference shares

The advantages of preference shares far outweigh the challenges. They offer an attractive after tax yield, are risk averse – an important consideration during a financial crisis such as the current one, and the issuers are predominantly blue chip corporates. With regards to listed preference shares, there is an expected decline in supply, which is positive in the investment world. Stobie says that at one point, there was an oversupply of preference shares which put pressure on the prices.

The tax legislation relating to secondary tax on companies (STC) is currently under reform. A new tax on dividends has been announced which should come into effect in late 2009. A new tax on dividends would have an impact on preference share holders who are used to receiving a tax exempt dividend yield. One should note however, that most preference share transactions include a “change in law clause” which is designed to protect the holder and the issuer against unforeseen changes to the tax regime. Grindrod Bank expects that the economic outcome of the changes will be neutral for both holders and issuers. How the practical administration and mechanics of this new tax will work is less clear.

There are two key challenges regarding listed preference shares. Stobie says, “Firstly, liquidity can be quite poor at times, because some of the market capitalisation of the preference shares are quite small. For example, a company might only have a R100 million market capitalization, which means that, to trade in large rand values in that share is problematic and they are usually quite tightly held. With the bigger banks this is less of a problem though.”

Secondly, there is a limited universe of issuers. There are 39 listed preference shares currently in the South African stock market, with only 18 being actively traded, at a total market capitalisation of around R23,8 billion. Of the 18, 11 are banks, so there is concentration within the banking sector.

Notwithstanding these two issues Grindrod Bank believes that the listed preference shares are offering attractive value to medium term investors. The preference shares are trading at historical lows whilst their yields (which have a inverse relationship to the price) are trading at handsome yields.

Grindrod Bank is involved in the preference share industry by way of two niche funds: The Grindrod Investments Trust and the Grindrod Diversified Preference Share Fund, launched in May 2008. In these funds, Grindrod has in excess of R1.6 billion worth of preference shares under management by a team that has a collective experience in this area of over 20 years. The investment objective of the Grindrod Diversified Preference Share Fund is to provide investors with an above-average after-tax return in the form of dividends. This is achieved by diversifying the portfolio’s investments across various preference shares and other dividend yielding assets. A minimum of 75% of the assets is invested in listed preference shares as well as other preference share investments that are treated as non-equity investments. This fund is currently yielding 13.5% which is tax exempt but excludes management fees.