Investors have had a love-hate relationship with the listed preference share market since the asset class first emerged in the mid-2000s. Initially the preference share market traded at an attractive premium to listing prices, however, this was followed by a downward trend towards their current, deeply discounted level. The asset class has, however, proven to be an excellent diversifier over certain periods, most notably over the 2008 Global Financial Crisis (GFC), and more recently in 2016 and 2018. As the index currently languishes around its all-time low, we revisit the asset class, the investment merits, some of the legacy issues which have dogged the asset class and the use-case going forward.
The asset class
The JSE has a relatively small opportunity set of preference share listings. The larger listings which form part of the FTSE/JSE Preference Share Index have the following characteristics:
- Hybrid instruments: Part equity and part debt – preference shareholders rank ahead of ordinary shareholders but behind debt holders within a company’s capital structure;
- Perpetual term: the shares have no maturity/termination date, investors can sell them in the market when they wish to disinvest;
- Yield linked to prime: the yield is expressed as a percentage of the prevailing prime interest rate (accrued daily);
- Mostly non-cumulative: The regulated, financial services entities which dominate the index all have non-cumulative terms, which means that if they choose not to pay any dividends one year, this missed dividend amount will not accrue and be added to any future preference share dividends before being allowed to pay ordinary shareholders their dividends (as would be the case with cumulative preference shares).
The investment case
The asset class is appealing for the following key benefits:
- Tax efficient income
Preference Shares pay a dividend yield which is taxed at 20% (the dividends withholding tax rate) for individuals, rather than at a maximum of 45% for (non-exempt) interest income. So, when one makes an after-tax evaluation of yields available from the interest-bearing market, preference shares are compelling.
For comparative purposes the process of ‘grossing up’ the yield is common practice. Below is an example of how to compare yields with different tax treatments.
The formula:
(Preference share yield x (1-Dividend withholdings tax @ 20%)) / (1-Personal tax rate) = Grossed-up comparative yield
For investors in the 26% tax bracket and upwards, this exercise is worthwhile. 10.5% – 14.1% is an excellent pre-tax yield when benchmarked against interest-bearing instruments from the same issuer (for reference, Prime is currently 7%).
- Dependable Yield
The preference shares making up the FTSE/JSE Preference Share index are all variable-rate instruments with their yields linked to the prevailing Prime rate and expressed as a percentage of prime. Given the variable nature of the yield, one does not face the usual interest rate or duration risk commonly experienced when holding fixed rate bonds. Over the history of the index, and except for Steinhoff and African bank, none of the regular preference share issuers have skipped a dividend.
What has happened over 2020?
Whilst we expect to see many organisations adopt a conservative view on cash retention and dividend polices during the current Covid period, it is not our expectation that preference share issuers will miss their dividends. Guidance thus far is to the contrary, and we expect these dividends to be maintained. Given the equity nature of the instruments, however, there are no guarantees.
- Relatively High yield
The grossed-up yield of 10.5% – 14.1% compares favourably to taxable interest-yielding instruments.
- Quality issuers
Over 90% of the index is made up of reputable financial services companies. The large banks: Standard Bank, Nedbank, FirstRand, ABSA and Investec make up 76% of the index. These banks are well capitalised and are operating within a highly regulated environment.
- Asset class “disconnect”
Preference shares enjoy a strong cash flow underpin to their valuations and while they have suffered from demand and supply shocks due to low liquidity over certain periods, they have exhibited disconnected returns from risky assets such as equity (the annual return correlation is -0.13). This makes them an excellent diversifier, most notably over the 2008 Global Financial Crisis (GFC), and more recently in 2016 and 2018. However, this means they may perform poorly in other years when risky assets perform well, e.g. 2017. This uncorrelated profile makes for a useful addition within a balanced portfolio.
Recent returns & current yields
The preference share market is down sharply YTD. On the flip side, this means that the forward yield, which is expressed as a percentage of prime, is higher (at approximately 139% of Prime). This equates to approximately 9.7%, or 10.5% – 14.1% grossed up pre-costs and tax.
Liquidity Concerns
Several factors have plagued the asset class over the years, and we think it’s fair to say that preference shares haven’t always been a well-understood asset class. By far the most impactful aspect is the liquidity within the market. Being highly illiquid, there are times that returns are subject to both demand and supply shocks, and small trades can move the market due to thin liquidity. As such, this asset class is best suited to investors that are comfortable enduring these periods to reap the longer-term rewards and would not find themselves forced sellers during times of market stress. For more details on legacy issues, please see the appendix.
Conclusion
We believe that preference shares have a place within a diversified income strategy, particularly for investors who have a high tax rate and are seeking tax-efficient income. The CoreShares Preference Shares ETF (share code PREFTX) ensures broad diversification across the issuances and provides a quarterly dividend. The asset class should be held over at least a 36-month period. The current pre-tax yield of c. 10.5% – 14.1% is attractive in this low-yield environment. For more information, please visit our fund page.
APPENDIX
Legacy issues
Several factors have plagued the asset class over the years, and we think it’s fair to say that preference shares haven’t always been a well-understood asset class. Here is an update on some of the factors, in addition to the liquidity concerns detailed earlier, affecting the asset class or the perception thereof:
- Changes to banking regulations and Basel III have meant that banks may no longer use preference shares (under their current terms) as primary Accordingly, the instruments have been ‘grandfathered’ to a point where they are no longer efficient for banks to retain on their balance sheets as they are deemed ‘debt’ rather than ‘capital’. We are of the view that this is a net positive for clients as the banks will need to buy back the preference shares in the market or seek a resolution with holders to redeem. In either case, this should result in additional value for current holders. Capitec is the only bank to have proactively bought back their preference shares. Others have sought permission from shareholders, but have not taken any further action so far.
- Introduction of Dividends Withholdings Tax (DWT): Whilst DWT is now a common part of our market, this wasn’t always the case. DWT replaced Secondary Tax on Companies in 2012 at the, then, same rate of 10%. The preference shares that were already in issue adjusted their yields accordingly. However, this rate has increased to 15% and then to 20% over the years with no further adjustments to preference share yields. Naturally any increase to this tax will be negative for the asset class but no more so than other dividend-yielding instruments.
- Corporate failures: African Bank and Steinhoff were both issuers of listed preference shares and both experienced major corporate failings. Given that this was within a relatively small group of preference share issuers, the effect was notable for investors in the asset class.
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