Preference shares offer good opportunity
For a unique opportunity to get an outstanding after-tax income stream, investors should consider investing in preference shares.
“Prices of preference shares have steadily declined over the past two years and the capital values of some are now up to 20% less than their original values,” says Dr Prieur du Plessis (pictured), executive chairman of niche investment manager, the Plexus Group.
“In addition to being available at exceptionally low prices, the effective dividend rate on preference shares is currently higher than comparable money market rates,” he says.
A basket of non-redeemable preference shares with a dividend linked to the prime rate will provide a tax-free yield of 12,4% to 15,9% a year at the current prime rate of 15,5%, says Du Plessis. This is equal to a taxable yield of 19,7% to 26,4% for a person with a 40% tax rate.
Preference shares are appealing for other reasons too. For instance, company profitability does not affect the prices of preference shares to the same extent as ordinary shares. The attractiveness of a preference share instead largely depends on its yield, or dividend rate, and the issuing company’s ability to meet its dividend obligations.
Should a preference share’s market price change, its income stream is not affected. A decline in capital values has no effect on dividends.
“Where the dividend rate is linked to the prime interest rate, there is a built-in hedge against inflation,” says Du Plessis. Since inflation targeting was introduced, interest rates have moved upwards in line with inflation.
As some preference shares do not have a redemption date, these investments can only be withdrawn by selling the shares. This means an investor can pass an unchanged income stream from non-redeemable preference shares to a spouse or final heir.
When selling preference shares, investors can profit if the selling price is higher than the original issue price. Be warned that there is a risk of capital loss if preference shares are sold at a lower market price, like now.
“The decline in preference share prices came as a surprise to the market,” says Du Plessis. He attributes the decline to regulatory changes and rising interest rates.
“In the 2007 Budget Speech an eventual abolition of secondary tax on companies (STC) and the introduction of a dividend tax of 10% was announced. As investors generally favour preference shares for their tax-free dividends, the announcement resulted in a negative sentiment towards preference shares.”
“Although issuers of preference shares indicate their intention to pass STC savings to preference share holders, some investors have adopted a wait-and-see attitude,” says Du Plessis. “We believe this negative sentiment will only dissipate once dividends do in fact rise to offset the dividend tax from March 2009.”
The abolition of tax on retirement funds has also impacted prices. Many preference share buyers have become sellers because retirement funds no longer require the tax savings and have achieved better returns from money-market instruments.
Preference share prices may also have declined due to the natural adjustment of the capital value of fixed-interest instruments in a rising interest rate environment, says Du Plessis. Where preference shares’ rates of return are linked to the prime interest rate, dividends have increased in response to interest rate hikes.
The opposite should also be true, so capital values should rise again in a falling interest rate environment.
“As preference shares are offered on different terms and conditions, investors should get specialist advice before summarily making an investment in these vehicles,” says Du Plessis.
