Preference for preference shares

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.