Happy re­turns

For­get the cap­i­tal gain or loss

Finweek English Edition - - Companies & markets - ADRI­AAN KRUGER

PREF­ER­ENCE SHARES that pay div­i­dends linked to the prime over­draft rate are still very pop­u­lar in­vest­ments – not only for in­di­vid­u­als who seek a known reg­u­lar in­come but also among fund man­agers look­ing for an in­vest­ment of­fer­ing low risk and a high div­i­dend yield.

They’re also an op­por­tu­nity for cap­i­tal growth from cur­rent low lev­els, as in­ter­est rates are in­creas­ing and the div­i­dend flows from pref­er­ence shares im­prove. No less than nine of the 16 prime-linked pref­er­ence shares cur­rently of­fer a prospec­tive div­i­dend yield of more than 9% over the next 12 months. Most of the oth­ers of­fer a div­i­dend yield of more than 8% – also look­ing at the div­i­dends you can ex­pect over the next 12 months.

Quite a few of the banks and in­dus­trial com­pa­nies that is­sued pref­er­ence shares will be declar­ing div­i­dends for the six-month pe­riod to end-De­cem­ber 2006 within the next few weeks, with the div­i­dend for the six months to June 2007 due in Au­gust.

The cal­cu­la­tion for the prospec­tive div­i­dend yield has been based on the ef­fec­tive prime over­draft rate for the six months to De­cem­ber 2006, while the div­i­dend for the next six months as­sumes an­other two in­ter­est rate in­creases.

“It’s gen­er­ally ex­pected that the SA Re­serve Bank will in­crease its repo rate by an­other 50 ba­sis points in Fe­bru­ary and again in April,” says Thebe Se­cu­ri­ties’ econ­o­mist Kristo Redlinghuis. “That will in­crease the prime over­draft rate to 13,5% – which will in­crease the pref­er­ence div­i­dend payable on prime-linked pref­er­ence shares.”

It’s that vari­able coupon that sets pref­er­ence shares apart from tra­di­tional deben­tures or bonds, where the value of the bond de­clines and the holder suf­fers a cap­i­tal loss when in­ter­est rates drop.

Con­cern­ing bonds, the sell­ing price is the only vari­able that can ad­just to changes in in­ter­est rates. So if the yield on other in­vest­ments in­creases, the price of a gilt must drop to com­pen­sate and of­fer a com­pet­i­tive in­vest­ment op­tion.

How­ever, the div­i­dend on prime-linked pref­er­ence shares in­creases to an ex­tent

with ris­ing in­ter­est rates, which in­di­cate that in­vestors should value those in­vest­ments as shares and not as bonds. In plain English, look at the div­i­dend you can ex­pect over the next year and com­pare it to other in­vest­ments.

In essence, in­vestors should re­mem­ber that they’re buy­ing an in­come stream and that the cap­i­tal gain or loss should be sec­ondary (as dif­fi­cult as that might be to ac­cept for those in­vestors that bought pref­er­ence shares at higher prices in the rush to get them at list­ing).

There’s no ques­tion that pref­er­ence shares of­fer good value at cur­rent prices. The for­ward div­i­dend yield on bank shares (used as com­par­isons, as most pref­er­ence shares were is­sued by banks) is around 4%, less than half the av­er­age yield of 8,5% on pref­er­ence shares.

The yield on prop­erty trusts is gen­er­ally be­tween 5% and 7%, but it com­prises mostly in­ter­est and is tax­able. The yield on Gov­ern­ment bonds at around 8,3% and fixed 12-month de­posits at banks at 7% to 8% are also sub­ject to tax. Those al­ter­na­tives of­fer an af­ter-tax yield of 3% to 5,5%, de­pend­ing on the le­gal en­tity.

In fact, this group of pref­er­ence shares seems out of line and could be due for a rerat­ing. To bring the af­ter-tax rate of re­turn in line with sim­i­lar in­vest­ments, th­ese shares can in­crease by as much as 20%.

The only un­cer­tainty (at this stage) are ru­mours that the tax sta­tus will change. That seems un­likely. Even so, the ef­fect might not be sig­nif­i­cant. Says FirstRand: “FirstRand pref­er­ence shares have the fol­low­ing in­her­ent right re­gard­ing tax law changes: the pref­er­ence share rate will be ad­justed if the div­i­dends be­come tax­able in the hands of the in­vestor to the ex­tent that FirstRand ob­tains a tax de­duc­tion.”

It isn’t sur­pris­ing that in­come funds have been big buy­ers of pref­er­ence shares. The ta­ble shows that the to­tal shares held by dif­fer­ent unit trusts (mostly in­come funds) in­creased sig­nif­i­cantly dur­ing the three months to De­cem­ber 2006, com­pared to the Septem­ber quar­ter.

FUNDS' HOLD­INGS OF PREF­ER­ENCE SHARES

Source: Thebe Se­cu­ri­ties

FOR­WARD DIV­I­DEND YIELD ON PREF­ER­ENCE SHARES

Source: Thebe Se­cu­ri­ties

FU­TURE AN­NUAL GEN­ERAL MEET­INGS

PAYMENTYMENT DATES

Source: Thebe Se­cu­ri­ties

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