Forget the capital gain or loss
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.