What's hap­pen­ing to prefs?

Finweek English Edition - - Creating wealth - JAY COWEN

DEAR VIC I read your ar­ti­cle on pref­er­ence shares with in­ter­est and have the fol­low­ing ob­ser­va­tions to make in the light of your com­ments that “the price of th­ese prefs should al­ways re­main around their is­sue price”, and that “the chance of their prices ever fall­ing be­low the is­sue price is slight”. • For a mo­ment, put your­self in the po­si­tion of an imag­i­nary in­vestor who has R100 000 to in­vest in ei­ther a money mar­ket de­posit that cur­rently yields about 8,5% (tax­able), or to buy some Absa pref­er­ence shares, that also yield about 8,5% (tax free) at to­day’s R914 mar­ket price. Sup­pos­ing our in­vestor friend earns a good salary and also has sub­stan­tial in­vest­ment in­come, chances are that he/she will be pay­ing tax at the max­i­mum mar­ginal rate of 40% on the in­ter­est earned on the money mar­ket de­posit, so that the real yield to that in­vestor would be only 5,1% af­ter de­duct­ing Un­cle Trevor’s share. Con­trast this with the full 8,5% that he/she would re­ceive from the Absa prefs, and the choice is pretty ob­vi­ous, even al­low­ing for the bro­ker­age in­volved. As for risk, I can’t be­lieve that pref­er­ence shares in Absa are more risky than an Absa money mar­ket de­posit. * This rea­son­ing would sug­gest that the pref­er­ence shares are ac­tu­ally quite un­der­priced in the mar­ket and should per­haps be more re­al­is­ti­cally priced to yield (say) 6,5% to fac­tor in their huge tax ad­van­tage over money mar­ket de­posits. With prime cur­rently at 12,5% the Absa prefs will pay 7875c per an­num, and at the sug­gested 6,5% yield the shares would be priced at R1211. Com­pare this with the cur­rent share price of R 914 and it looks as if the shares are in fact about 30% un­der­priced! Any in­ter­est rate in­creases or de­creases that the Re­serve Bank gov­er­nor may an­nounce will not be of any con­se­quence to the hold­ers of the pref shares, since their div­i­dends will be au­to­mat­i­cally ad­justed to re­flect the changes, and money mar­ket rates will also ad­just in line. Now try ex­plain­ing to the own­ers of Absa pref­er­ence shares pur­chased at R1 000 on their is­sue in May 2006, why they have suf­fered an 8% cap­i­tal loss since then.

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