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Preference for preference shares

An unappreciated asset class.
Image: Shutterstock

Preference shares are an underappreciated asset class, particularly for income-seeking private investors who are less constrained than institutions when it comes to liquidity.

But first, what are preference shares?

Preference shares are shares with special rights attaching to them. Each preference share is unique but most have the following characteristics:

  • Dividends: Preference shares typically pay a dividend that is based on their par value multiplied by a percentage of the prime rate. Note that this will create a ‘yield’ on the par value of the share, but the actual (dividend) yield of the preference share is this dividend relative to the price you are paying of the preference share in the market.
  • Cumulative: In most cases, this dividend is cumulative, meaning that if the company does not pay it in one year, then the obligation to pay rolls into the next, and so on. Many preference shares even prohibit a company from paying dividends to ordinary shareholders until the cumulative preference shares have been paid.
  • Redeemable: Preference shares can be either non-redeemable or redeemable.
  • Voting rights: Most preference shares do not come with voting rights. Sometimes when a preference dividend is in arrears, the holder may gain voting rights.
  • Middle-of-the-queue: While depositors, creditors and bondholders typically rank ahead of preference shares in any liquidation/bankruptcy, preference shares will rank ahead of ordinary shares and, thus, there is a degree of capital protection here.

Preference shares are like bonds in the way that any profits over their required dividend does not accrue to them but goes to ordinary shareholders. That said – and contrary to most bonds – preference shares typically have floating rates and, thus, the Reserve Bank announcing a rate cut or hike should not, per se, see a concomitant movement in the preference share prices. Fixed-rate bonds, though, would see their market prices move depending on interest rate movements.

Why would a preference share not necessarily move on a change in South Africa’s repo rate?

If a bond is paying R10 interest a year, then the repo rate moving from 10% to 5% should see the bond’s market price double. E.g. R100 (=R10/10%) fair value of the bond moves to R200 (=R10/5%).

A preference share in the same example would simply see its dividend change as the interest rates change; thus, its market price would (theoretically) remain stable.

What does a preference share’s price reflect?

The short answer is credit risk. The higher the credit risk, the higher the preference share’s yield in the market, and vice versa.

(The long answer includes rising marginal value at lower interest rates, the liquidity of the actual instruments in the market and/or future expectations regarding macro events and our rates cycle.)

If we shift our view to our JSE-listed preference shares, you will see a lot of our banks have issued them. Given that our banks are both well-capitalised and are basically ‘underwritten’ by the Reserve Bank, this is a great thing as it means that these preference shares offer relatively lower credit risk than most listed companies.

Adjusting for the current prime rate of 7% to calculate the different preference shares’ forward dividend yields, we get the following spread across the JSE:

JSE-listed preference shares

Underlying company Preference share code Price

(cps)

Par- value 

(R/share)

Dividend:

% of prime

Implied forward dividend (cps) Forward 12-month yield (%)
Invicta IVTP 6700 R100 102.0% 714.00 10.66%
Investec INPPR 6965 R100 95.0% 665.00 9.55%
Grindrod GNDP 6529 R100 88.0% 616.00 9.43%
Sasfin SFNP 6125 R100 82.5% 577.50 9.43%
Discovery DSBP 7450 R100 100.0% 700.00 9.40%
Investec Ltd INPR 6252 R100 77.8% 544.46 8.71%
Netcare NTCP 6700 R100 82.5% 577.50 8.62%
PSG PGFP 6900 R100 83.3% 583.31 8.45%
Nedbank NBKP 695 R10 83.3% 58.33 8.39%
Absa ABSP 59900 R1 000 70.0% 4 900.00 8.18%
Investec Bank INLP 7250 R100 83.3% 583.31 8.05%
Standard Bank SBPP 6730 R100 77.0% 539.00 8.01%
FirstRand FSRP 6800 R100 75.6% 528.92 7.78%
Capitec CPIP 10600 R100 83.3% 583.31 5.50%

Source: Various market sources and own workings and assumptions, ignoring Steinhoff, Nampak and Northam preference shares.

Relative to a cash account’s measly 0.5~3% per annum return, achieving an 8~10% yield on a relatively safe investment is attractive. Even after we take out dividend withholding tax of 20%, this remains equal-to-higher than the most domestic yielding investments of equivalent safety.

So which preference share should you invest in?

There is a preference share exchange-traded fund (ETF) – CoreShares PrefTrax – but its high total expense ratio (0.45% pa) and other costs (e.g. spread) see it yielding a less attractive c.7.5% (forward yield at current prime rate).

Particularly given the huge weighting of the banking preference shares in this ETF, why not just buy a hand-selected basket of the preference shares directly in the market? As demonstrated below, this should arrive at a more attractive yield (c.8.5% or +13% higher than the PrefTrax) without an added layer of costs between you and the underlying investment.

Hand-selected basket of JSE-listed preference shares

Underlying company Preference share code Forward 12-month yield Weighting in portfolio
Standard Bank SBPP 8.0% 16.7%
Absa ABSP 8.2% 16.7%
FirstRand FSRP 7.8% 16.7%
Nedbank NBKP 8.4% 16.7%
Discovery DSBP 9.4% 16.7%
Grindrod GNDP 9.4% 16.7%
Total portfolio 8.5% 100%

Source: Various market sources and own workings and assumptions.

Particularly in a world with low-to-negative rates and collapsing yields, preference shares offer the private investors a potentially attractive, relatively safe and often underappreciate option that should be considered by those seeking income.

Keith McLachlan is a small cap analyst.

COMMENTS   7

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The Preftrax ETF price dropped almost 30% in the past year.

Nothing attractive about that.

Interest rates/prime dropped 30%. Although these are floating instruments, people seem to trade them like fixed interest instruments on the pref formula.

Is the percentage of prime the theoretical interest rate? It seems that Capitec at 83% of prime yielding 5% is seen as a safer bet than firstrand/standard bank at 75% of prime yielding 8%?
Why would larger banks that have lower payments of prime yield more than Capitec?

Ja, bit of a puzzling recommendation basket. Why ignore Investec and Sasfin both paying higher estimated rates compared to FR, Std & Nbank?

The ruling price is probably influenced by how close the next income date is as the holder at a date is entitled to the dividend whether it was owned for a week or almost half a year.

That forward yield column should deduct the 20% tax as far as individuals are concerned?

The best deals in pref were to be found in the 2007/8 financial crisis. A bunch of funds were by mandate not allowed to own securities below a certain rating. So one could buy OldMutual prefs at a ruling 35, that were paying 8. The price went back to 100 pretty quickly and it paid the 8 all along.

Ask investors’ opinion who held Ecsponent Pref Shares the past year.

“A guarantee is only as good as those giving it”

Pref shares are relatively useful investments for babies and the elderly, but so are diapers.

End of comments.

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