[TOP STORY] Understanding preference shares

Preference shares are hybrid financial instruments, predominantly exotic equity or debt instruments: Keith McLachlan of Integral Asset Management.

SIMON BROWN: I’m chatting now with Keith McLachlan, investment officer at Integral Asset Management. Keith, I appreciate the early morning time. Preference shares – let’s kick off quickly. In essence, these are not normal equity shares. They’re more, they are debt instruments, albeit on the JSE, and they pay dividends linked to prime.

KEITH McLACHLAN: Absolutely. Morning, Simon. Preference shares are hybrid financial instruments, and you’re correct about the ones listed on the JSE. They’re predominantly effectively debt instruments, but that’s not to say all preference shares are. Some of them can be convertible, some of them have equity portions to them and things like that. The point is that they’re exotic equity or debt instruments. So each one can be written with very unique terms to it. It’s best to understand that.

SIMON BROWN: Actually, I remember that – the terms ‘non-redeemable’, ‘non-cumulative’, non-, non- and all the other bits and pieces there. What we are seeing in our market is that we’ve got to know which ones are which; but we are seeing a shrinking sector generally. Back in the sort of 2000s, it was a fast-growing sector, but it’s shrinking and disappearing, particularly from some of the big banks.

KEITH McLACHLAN: Yes, it’s quite sad to see that. But what’s happened in the background is Basel III liquidity requirements and our view of our domestic Reserve Bank have placed the local banking preference shares into a very unattractive tier of liquidity – [that is] not very liquid. So it’s in the banks’ interest to buy them back because, whereas these were quite cheap funding mechanisms back in the day and hence they were listed and issued and they made use of them, it’s now the complete opposite.

They’re actually quite expensive from a banking perspective. So we are seeing all these banks buying their preference shares back, which is quite sad because it’s wonderful to have these exotic instruments listed.

But that’s not to say that those are the only instruments. Grindrod, Invicta, Netcare  – they have preference shares as well.

SIMON BROWN: That’s it. There is a fairly chunky range of what I would call sort of ‘tier two’. So they’re not [of] the big four/five banks, but they’re still perfectly quality, and there’s some good yield lurking around in the space.

KEITH McLACHLAN: Definitely. I would say of the non-banks, the biggest non-bank preference share attaches to Discovery. Now you’ve got to be careful. It’s code is DSBP, and what that says to me is that it actually doesn’t attach to the whole code. It attaches to a subsidiary underneath it. The moment you’ve effectively got a code that’s different from the big entity, it’s not attaching to the big entity, much like PSG’s old preference shares used to.

But insurance liquidity requirements, which are SAMs, [are] quite different from the banking ones, and at this point they’re not being penalised from it.

But below that you’ve got Grindrod, you’ve got Invicta, you’ve got Netcare, you even have Steinhoff – but I’m not sure we should talk about that one. [Chuckling]

SIMON BROWN:  I’d actually forgotten about that Steinhoff one. What sort of yields? I mentioned upfront that they’re linked to prime, so usually they’re paying a percentage of the prime rate. They of course paid off their nominal, their sort of issue price – not necessarily the price that they’re trading at in the market. But we are seeing some fairly good sort of high single-digit yields, of course paid as dividends which, if you’ve got tax implications, can be quite a benefit.

KEITH McLACHLAN: Absolutely. So ignoring, for example, RECM & Calibre – which is technically also a preference share but it attaches to assets, and it actually operates effectively like equity, not like debt – of the debt-based preference shares all of them on our market pay a percentage of prime based on their par value. Now [as to] the price they trade at in the market, they’re all trading somewhere between 80% to 90%, somewhere in that range of par value, and that creates a yield. So if we look at the current prime rate and we roll it forward, so we assume it’s flat, which at this point we are actually in a rising interest-rate environment which implies a forward prime rate, you are looking at a dispersion of forward dividend yields of somewhere from 8% to 9%. Invicta, for example, is as high as 10%.

These are quite attractive dividend yields.

Obviously, if you’re coming from a private invest perspective, you need to chop out dividend-withholding tax. But these are still very attractive post-tax yields, especially if you’ve tapped out in terms of your interest exemption in your personal income tax.

This is a nice way of generating relatively high yield above and beyond that that’s actually not correlated to all the normal things.

SIMON BROWN: There’s the ETF from CoreShares that’s got some of the biggies in it [CoreShares PrefTrax ETF]. So that makes it perhaps a slightly lower yield. You can essentially build your own. I know you like Invicta, I know you like the Grindrod one. You could sort of buy two or three, maybe four of them and put your own sort of preference-share portfolio together for that yield.

KEITH McLACHLAN: Well, certainly. I would argue the non-banking preference shares are becoming more attractive as the banks de-list theirs. So [in] a market with less opportunities in it, those remaining opportunities become more attractive because investors have [fewer] alternatives other than investing in them. It is going to be interesting to see, as the banking market de-lists all their preference shares eventually and FirstRand preference shares, for example, [are] under cautionary to de-list – what exactly pref tracks realigns to.

The shortcoming of ETFs is it’s a forced buyer of the remaining preference shares, and that pool gets much smaller and smaller.

So we’ve used Grindrod and Invicta preference shares to good effect. They’re both reasonably liquid. They’re both attached to well-run businesses in the background with comfortable balance sheets.

Because, remember, profits are great but you’re actually looking at credit risk here. So counterparty risk is quite key.

We think those two preference shares are quite attractive and become increasingly attractive as the banking portion of the market shrinks.

SIMON BROWN: That’s a good point. CoreShares – I’ve chatted with Gareth Stobie around this –  are struggling.

Listen/read: [TOP STORY] How CoreShares will fit into 10X investments

They’re sort of 65% of the portfolios. If Standard Bank, Absa and FirstRand pref shares disappear, what do they do? I suppose they make a plan, but plan’s not the plan.

Keith McLachlan, investment officer at Integral Asset Management, I appreciate the early morning.

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