A preference for dividends
Pref shares can be used as a higher-yielding proxy to cash and bonds, but they are often inferior to equities, writes Warwick Lucas
There is a surprise topranking exchange traded fund (ETF) in the one-year returns category — the CoreShares Preftrax. Some discussion about preference shares seems necessary.
Between July 2008 and February 2022, the JSE preference share total return index moved from 1,000 to 3,307. That corresponds to a compounded annual return of 9.2% over 13½ years. This is 4% below the return of about 13% that you would expect from equities over such a timeframe and 2% above the about 7% that prevailed for cash rates in SA.
The primary reason investors make money in preference shares is the high dividend yields. Preference shares are basically loans or credit instruments which pay dividends; this makes them useful instruments for loss-making companies, start-ups and any company looking to create zero recourse debt.
Prefs are riskier than bank deposits as preference shares rank behind depositors and other creditors in a bank liquidation. Thus risk needs to be diversified and an eye needs to be kept on factors affecting the creditworthiness of issuers.
SA’s big banks are mostly well regulated and supervised and underpinned by the Reserve Bank.
Pref share prices fell from 2012 to 2017, and again in the Covid crash. Prices fell because the banks’ credit ratings dropped thanks to the damage done to SA’s sovereign credit rating by state capture and credit ratings downgrades. When credit ratings are stable, returns on prefs improve. The yield is higher than cash — and the dividend tax rate works for high-rate taxpayers. Prefs can be attractive to holders of closed corporations or proprietary companies as these companies get a dividend tax exemption and pass through the full dividend to their holders.
The coupons are determined by formulas made up of a percentage of the prime overdraft rate on the initial issue price. Being linked to a floating interest rate, they don’t have a lower interest rate risk than bonds (which fall when interest rates rise).
From the banks’ point of view, prefs are expensive funding. This has been borne out by the fact that Capitec, Nedbank,
PSG, Sasfin and Investec all bought back and cancelled their listed prefs in recent years. If it’s expensive for the banks, then it is cheap for the holder (you). It could well be that other banks may consider similar actions on their prefs, depending on their capital adequacies.
The prime overdraft has limited influence on pref prices, as the yields track a percentage of prime.
The driver of the widening gap between prime and the AAA bank pref yields was the introduction and subsequent hiking of dividend taxes. The coupons of pref shares were at a premium to repo until 2009, whereafter the imposition of dividends tax pushed them into a discount.
Comparing risk and return of prefs to cash
Using periodic one-year returns over the past
14 years, on average only one year in four had a negative total return and 10% of sample periods had a loss that exceeded 5%.
This was all the more notable for including a pandemic event and credit downgrade — rare events, and both in the past.
This infers that pref share returns are quite stable, though clearly much less so than cash.
The indexed returns from prefs are not markedly differ
Prices fell because the banks’ credit ratings dropped thanks to the damage done to SA’s sovereign credit rating by state capture and credit ratings downgrades
ent from cash.
But they are markedly different when tax factors come into play — in the hands of high-rate taxpayers!
When should preference shares be avoided?
The Bank has consistently run real interest rate policy in the past 15 years, so preference shares have almost always provided a net real coupon over inflation. If the Bank becomes excessively dovish and runs low or negative real interest rates, then pref shares will suffer like bonds — namely, prices will fall to reflect a higher required rate of return.
Our interest in pref shares stems from their use as a higher-yielding proxy to cash and bonds, but they are inferior to equities over the long term.
Investors can access the preference share index through the CoreShares Preftrax ETF. It is a relatively “narrow” index as the top four holdings are all big banks’ prefs and comprise 80% of the index. Still, in exchange for your 0.56% total expense ratio you get issuer diversification, your dividends get paid quarterly and, with a market cap of R383m, there is a decent secondary market for private individuals inside the market makers bands.
“If the Bank becomes excessively dovish and runs low or negative real interest rates, then pref shares will suffer