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Are preference shares worth a look if you want yield?

Small-cap analyst Keith McLachlan calls preference shares ‘quite a unique asset class…somewhere between equity and debt’.

SIMON BROWN: I’m chatting now with Keith McLachlan, a small-cap analyst currently midway through his gardening leave. We are talking preference shares. Everyone’s hunting out yield at the moment. I mentioned interest rates are at their lowest since the seventies, that’s two generations. So where do we find some yield? There are options out there and one that Keith was writing about just yesterday is preference shares. 

Read: Preference for preference shares

Keith, morning, I appreciate your time. Before we move into some details, preference shares are essentially debt instruments issued by listed companies. A lot of them are banks, but not all are banks. We’ve got Grindrod, we’ve got Invicta, we’ve got others and you are taking on some of their debtors as an investment.

KEITH McLACHLAN: Morning, Simon. A preference share is quite a unique asset class and lies somewhere between equity and debt. The company has issued it. It’s a class of shares that has some unique attributes attached to it, and each one is different. 

So, although there are common attributes across them, don’t assume one preference share is exactly the same as another, because they can be written differently. But as a unique class of share with a yield attached to it, it has elements that are much like investing in fixed income. At the same time, it has rights attaching to it that are similar to equity. 

So they are very useful instruments for generating an income, and that income will typically be a dividend. Obviously, they are tax-free after dividend-withholding tax, and not part of the interest exemption. So (they have) very different characteristics but are a very useful instrument to generate a yield.

SIMON BROWN: You don’t get to vote and there is a whole bunch, as you say. What you do get is typically the payments are going to be linked to prime. As prime is moving you will get the benefit and they’ll pay 70% of prime, or in some cases +100% of prime. I suppose your risk here – although we’ve never seen it in our current environment – is a default. 

I’m looking at the companies issuing [them] and, even if you move down to those second tiers – the Netcares, the PSGs, the Sasfins, Grindrod and so on – my sense is they can afford this. This isn’t bankruptcy now. Steinhoff, African Bank both went down with preference shares attached to them. But if the business is operating, they can typically pay this.

KEITH McLACHLAN: Definitely. Much like a debt instrument, you’ve got counter-party risk here. There’s credit risk. These instruments have a guaranteed dividend stream, and you’re absolutely correct, most of them are attached to … prime which, interestingly enough, is more attractive at low-interest rates than it is at high-interest rates, given that prime often has a nominal gap between that and repo. 

But you’ve got counter-party risk, or credit risk, and the chance is never zero – it might be low, but it’s never zero – that the parent that issued the preference share in fact does not pay, goes under, in which case it’s also important to realise that these preference shares rank ahead of ordinary shares in terms of liquidation and bankruptcy.

So you’re a little bit further in the queue in terms of getting your capital back. You are probably behind bondholders and almost certainly behind deposit holders and creditors, but there is some degree of capital protection which, once again, is unique to this almost small and out of the way asset class.

SIMON BROWN: You mention that capital protection. One of the things with preference shares is that there is a risk of capital loss. There is a benefit, potentially, of a capital gain. The point is that this is not going to be linked to the share price. If the share price goes up 50%, your preference share, in theory, shouldn’t move because it’s got nothing to do with the operations of the business. It’s simply got to do with those dividend payments that it will make?

KEITH McLACHLAN: Yes or no. Like anything in economics and finances, it’s not that simple. So if the share price goes up dramatically because there’s been a credit-positive event – meaning the company was in a bad place and it’s now in a good place – one would argue that the preference shares are more valuable because your credit risk is lowered, and hence you’re willing to pay a lower yield on it – that is, a higher price. So don’t view the things as not linked; there is a correlation, but it is not as clear as that. 

SIMON BROWN: I take your point on that. And if I look down the list – and you’ve published the list here – at the top of it is Invicta paying over 10%, Grindrod there at 9.5%, with Investec, Sasfin 9.5%. Down at the bottom of the list is Capitec paying 5.5%. That’s not deeply attractive – you can get that in a bank these days, I suppose. But you could put together a basket of really high qualities –  Grindrod, Discovery, Nedbank, FirstRand, Absa, Standard Bank –and come out at a forward 12-month yield of 8.5%. Even after tax that is better than you’re probably getting in a bank. And of course, any money you earn in a bank above the limits is also subject to tax at your income-tax rate.

KEITH McLACHLAN: Absolutely. And it’s quite important that the credit risk you’d have in that instance is probably not because you’re buying the big banks. It is the big banks’ credit risk. So you’ve got a very comfortable credit risk, backstopped by the Reserve Bank effectively, and it’s after-tax. 

There is an ETF in this space and one can buy it and get a broad sector exposure, a broad-sector exposure so heavily weighted towards the big banks’ prefs. And in fact, the Ter (total expense ratio) ratio is so high on the ETF that the moment you chop that out of the yield, it’s more attractive just to go directly and buy these instruments. 

Now, the reason they haven’t been published as much and people aren’t as aware, and they’re not sitting in more portfolios, is because there are liquidity constraints in these preferential shares.

The big institutions would love to buy them, but they cannot.

And this in fact is the advantage for private individuals. One can selectively build a nice old basket here, diversify your income exposure, and do so on a tax-free basis with arguably very low credit risk into our big banking sector. 

SIMON BROWN: Absolutely. And then as prime rises – the Reserve Bank says it’ll be going up later this year; I’m not convinced –the yields will improve and you’ll get that uplift in the same space. Preference shares, if you’re looking for yield, are absolutely worth a look.

That’s Keith McLachlan. Keith, I appreciate your early morning time.

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