Shed­ding light on prefs

Finweek English Edition - - Letters - JAY COWEN

THANK YOU for your fur­ther ar­ti­cle on vari­able rate pref­er­ence shares in Fin­week of 8 Fe­bru­ary.

At the risk of be­labour­ing the is­sue, it seems, with re­spect, that you are still miss­ing a vi­tal point on the pric­ing of th­ese in­stru­ments.

While I agree that the rate at which the div­i­dends are linked to prime is im­por­tant upon their ini­tial is­sue (as yield would be when is­su­ing a new gilt), there­after it be­comes quite sim­ply a ques­tion of pric­ing the div­i­dend flow­ing from th­ese in­stru­ments…ie in ex­actly the same way as gilts are con­tin­u­ously re-priced by the mar­ket in re­la­tion to their in­ter­est pay­ments, or the man­ner in which com­mer­cial prop­er­ties are val­ued as a func­tion of the rental in­come pro­duced. The dif­fer­ence in the case of pref shares be­ing the vari­abil­ity of that cash flow and its tax-free sta­tus.

The crisp is­sue there­fore, is to de­ter­mine what cap­i­tal value should be at­tached to each rand of div­i­dend flow…ie if the pref­er­ence share is to be priced to yield (say) 6,5% to the in­vestor, then each rand of that div­i­dend cash flow would have a cap­i­tal value of R15,38 (ie100c / 6,5%), and at a 7,0% yield each rand would have a cap­i­tal value of R14,28, and so on to any given yield that the mar­ket thinks is ap­pro­pri­ate un­der pre­vail­ing cir­cum­stances.

Be­cause the yield at is­sue date is a mat­ter of his­tor­i­cal in­ter­est only and bears no sig­nif­i­cance to pric­ing there­after, I see no log­i­cal rea­sons which sup­port your con­tention that the mar­ket price of prefs should nec­es­sar­ily closely or­bit their orig­i­nal is­sue price, any more than a gilt should be priced at par (un­less it’s about to be re­deemed), or a com­mer­cial prop­erty should be priced at its con­struc­tion cost.

In view of the sig­nif­i­cant tax ad­van­tage of­fered by vari­able rate pref shares to in­di­vid­u­als pay­ing a high rate of mar­ginal tax, it seems that the ap­prox­i­mate 8,5% yield cur­rently at­tached by the mar­ket to most of the listed bank pref­er­ence shares is ex­tremely gen­er­ous, mak­ing them very at­trac­tively un­der­priced in to­day’s mar­ket.

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