A good option for stable income?
Investing in company ordinary shares is the most common means of investment on the JSE. Investors often overlook their more stable but less exciting cousin - the preference share. Preference shares are used by those investors looking for a fixed dividend stream. Unlike ordinary shares which offer dividends based on performance, preference shares offer a fixed dividend normally linked to the prime interest rate.
Key traits of preference shares
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Preference share dividends are set in advance and offer an investor a fixed percentage return based on the prime lending rate. This means that as the Repo rate increases so does the monetary value of dividend and vice versa. Ordinary share dividends are not set in advance, meaning dividends may decrease on the back of weakening profitability.
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Preference share dividends must be paid when the company declares an ordinary dividend.
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Voting rights are forfeited when purchasing a preference share as opposed to an ordinary share. Preference shareholders will have no say with regards to the way the company is being run or vote at a company's annual general meeting.
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The value of preference shares does not necessarily coincide with the value of the ordinary shares of the company, but is rather influenced by the Repo rate because its cashflows or income stream is a function of the prevailing benchmark interest rate.
Different types of preference shares
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Cumulative preference shares: Any dividends missed by the company will be made up in the future.
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Non-cumulative preference shares: Any dividend that is missed by the company will not be made up in future and is foregone by the investor. Buying a non-cumulative preference share will typically offer a higher yield over a cumulative preference share as the risk taken on by the investor is higher.
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Redeemable preference shares: The issuing company can redeem the preference share held by the investor at a future date for a fixed amount. This is quite like investing in bonds. Investors need to compare yields offered by the different fixed instruments as the risk parameters are naturally similar.
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Perpetual preference shares: These preference shares will not be expressly purchased back by the company in future. It works more like an ordinary share in that investors will have to sell the preference share in the market top receive a return of the capital amount invested.
Positive attributes of preference shares
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As the cash flows received by investors are dividends, only dividends tax is payable at a rate of 20% for individual investors. This makes the after-tax yield attractive as similar fixed instruments such as a fixed deposits or bonds will be fully taxable in the hands of the investor as the income stream is considered interest income.
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Preference shares offer low correlation with other asset classes making the asset a useful diversification tool to spread portfolio risk.
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Basel III regulations have resulted in banks purchasing back preference shares from shareholders at a premium. This has reduced the supply of preference shares in the market and driven up demand which has been supportive for prices.
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Capital volatility is generally quite low and while there will be some movements in capital from time to time, the bulk of return from these instruments are generated by dividends.
Source: Bloomberg, FNB Wealth and Investments
Negative attributes of preference shares
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Preference share dividends move with interest rates which means that if interest rates decline, preference share capital values decline. However, the opposite is true when interest rates increase.
Source: Bloomberg
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Preference shares tend to underperform ordinary shares in terms of capital value and do not benefit from higher earnings which will push up the shareholder return profile for ordinary shareholders. This is because preference share dividends are linked to benchmark interest rates and not company performance.
Current comparable after-tax yield
Source: Bloomberg, FNB Wealth and Investments
20-year gold price in USD/oz. and the USD/ZAR exchange rate
Source: Bloomberg
Investing in fixed income instruments is a great way to diversify a portfolio. The recent market pull back on the global pandemic offers an opportunity for investors to explore additional instruments which may have been overlooked in the past. Preference are not only offering decent yields and diversification benefit but are also more tax efficient investments than traditional fixed income instruments and provide more certainty of cash flows than ordinary shares.
