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Friday, August 1, 2008
Getting preference

As the bad economic and market news continues to dominate, investors are urgently looking for new ways to grow their wealth and realise excellent returns - without undue risk. One investment class which provides a low risk, stable source of tax-free income in good and bad times is preference shares. Particularly suited to corporate investors or high net worth individuals, there are two key preference share options redeemable preference, and perpetual preference shares. The former is better suited to the current conditions.

Tienie van der Mescht, MD of Sanlam Collective Investments, says that preference shares are those issued by a company that ranks as a claim against the issuer in preference to ordinary shares, but behind any other claims such as unsecured debt. However, in the case of redeemable preference shares, the subordinated nature is mitigated by combining the share with a guarantee.
He explains that preference shares are generally used either by high net worth individuals who have utilised their interest exemption, or by corporate investors who are South African tax residents, are in a tax-paying position, have surplus cash and need secondary tax on companies (STC) credits.”They generally offer higher after-tax returns than a comparable interest-yielding investment.”
In most instances, he says dividend returns are linked to a percentage of the prime lending rate or Johannesburg Interbank Agreed Rate and are payable quarterly or semi-annually. A small percentage of preference shares offer a fixed dividend rate. Dividends are currently tax free if they are held for longer than three years, or if a material change in the terms of the preference shares does not occur.
As for the two types, redeemable and perpetual preference shares, he says that each category has its own level of risk, so investors should check that they are earning an appropriate return.

Redeemable preference shares

Van der Mescht says that redeemable preference shares are packaged by banks and insurers for distribution to the corporate market. “They are issued off-market as a private trade, and are unlisted. As these are typically wholesale investments, denominations are large, varying between R1 million and R20 million.
“These investments are redeemable on a fixed date, normally three years after issue, and capital is repaid in full. No market risk exists for investors in such instruments.”
Dividend payments are prime rate-linked and cumulative. The investor’s claim for dividends accumulates over time at the contracted dividend return. Investors typically invest in these instruments as a buy-to-hold investment, in investment sizes that can exceed R400 million. Secondary market trades rarely happen and exist only by private treaty.
“As an alternative to investing directly in preference shares, clients can buy collective investments whose underlying assets are preference shares,” says Van der Mescht. One such fund, the Sanlam Alternative Income Fund. The unit price of this low risk fund remains fixed at 100c. The return is mainly in the form of tax-free dividends, with a small portion of taxable interest income.

Perpetual preference shares
Perpetual preference shares have equity characteristics. Investors have no claim to their capital as these are non-redeemable, except in the event of specified credit events.
The return is linked mainly to the prime lending rate. Investors have no claim to dividends unless and until they have been declared by the issuer. Since dividends are issued on preference shares before being issued on ordinary shares, the likelihood of dividends being passed is small.
“Perpetual preference shares are first distributed in the primary market, mainly by private banks, and investments can be made in relatively small denominations,” says Van der Mescht. “The instruments are traded though the normal stock broking channels. Although trade is thin and liquidity is limited, trading volumes are not limited. Most preference shares listed on the JSE are perpetual preference shares.”
As history has proven, significant market risk is assumed by investors in these instruments, he says. This is because the investor, when exiting from the investment, has to sell the listed investment in the secondary market at a price that can fluctuate.
He explains that the selling price can fall below the original issue price for various reasons. This may happen due to an excess supply of perpetual preference share issues, overselling by investors (for example due to rumours of tax changes or new issues that drive down the price of existing issues) or the impact of low liquidity.

The table below summarises the key differences between the two types of preference share:


Copyright © Insurance Times and Investments® Vol:21.7 1st August, 2008
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