What's happening to prefs?
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.