Are preference shares a safe haven?
By
Associate Editor
David Stevenson
Oct 03, 2008
Billionaire investor Warren Buffett has bought into the financial sector, putting $5bn into investment bank Goldman Sachs. But Buffett didn't buy just any old shares – he snapped up preference shares, bagging himself a 10% dividend. You might not be able to get the same deal as Buffett, but many British banks also offer preference shares, plenty of which are on juicy-looking yields. So is now the time to follow Buffett and buy?
What are preference shares?
A company's capital can be formed of two types of share – ordinary and preference shares, or "prefs". Ordinary shares, otherwise known as equity shares, are by far the most commonly held. Ordinary shareholders are the company's ultimate owners and have the right to a share in the company's profits. They can also vote at the company's annual general meeting (AGM).
Preference shares, on the other hand, are a hybrid of equity and debt, with a number of key differences from ordinary stock. Preference shares usually have no voting rights, but they bring other advantages. For one thing, preference share holders rank higher than ordinary shareholders if a company is liquidated, although they still stand behind holders of all forms of the company's debt, including debentures, loan notes and what's owed to the bank.
Another key difference is in the dividends. Preference share dividends are fixed, so they don't vary with the company's profits, unlike ordinary dividends. This means they don't rise in good times, but they do offer added protection in hard times. For one thing, pref dividends must be paid out in full before any dividend can be paid to ordinary shareholders. Also, most preference shares are also cumulative. So if one year the company has to cut the dividend, or ditch it altogether, then the unpaid amount is added to the next dividend payment. Because of this cumulative element, preference shares are dealt "dirty price", i.e. with the quoted price including any accrued dividend, unlike bonds where accumulated income is shown separately. Some banks have issued non-cumulative preference shares to build their basic capital levels. In this case, if there is no payout, then pref holders would receive stock equivalent to the nominal value of the unpaid dividend.
The three types of preference shares
Broadly speaking, there are three types of preference shares: leaders, issued by large and relatively liquid stocks, generally banks and insurance companies; higher-coupon second-liners, which tend to be difficult to trade; and finally, low-coupon prefs, which are priced substantially below their "par" or face value. Investors often buy into these on lower yields than the leaders to collect a healthy capital gain on redemption.
Most preference shares are undated, though some have a finite life and some are "callable", meaning they can be redeemed by the issuer at a specified date – at "par" (face value) of 100p per share. So it's usual to work out the "yield to call" (or redemption). That means you assume that the stock will be redeemed and the capital repaid at par on the set date. If the stock is trading below par, this can produce a higher yield.
What about tax?
Preference share dividends are subject to the same tax treatment as ordinary share dividends, i.e. there's no further standard-rate tax to be paid on the income you get. So while yields are quoted on a net basis, to get a true comparison with comparable fixed interest instruments, you need to "gross them up" at the standard tax rate. Here's an example: Aviva has an 8.375% cumulative preference share. It currently yields 7.285% net at the price of 115. But on a gross basis, the yield is 9.1%, well above the 4.6% available on UK government's ten-year gilt-edged stock.
So what's the appeal of preference shares?
As the global credit crisis has grown, the values of ordinary shares have been badly battered. Prefs, in contrast, are far less volatile, partly because they are less widely traded. And although yields on ordinaries have risen as prices have fallen, preference shares still tend to pay out more, with the added security that they rank ahead of the ordinaries. And as UK interest rates look likely to fall later this year while the economy worsens, the relative worth of those fixed pref dividends will rise, which would usually push pref prices up.
It all sounds great. There's just one problem – and it's a big one. The companies that have tended to issue preference shares are financial stocks, looking to top up their capital ratios. And unless you have the kind of firepower that Buffett can employ, the chances of you getting a deal that makes any financial stock worth the risk at the moment is slim. For anyone who does believe that this week's soaring fear levels marked the turning point for financial stocks, the NatWest 9% (LSE:NWBD), currently yielding around 11%, could be cheap assuming Royal Bank of Scotland survives the current turmoil intact. Or there's the Norwich Preference Share Fund (0845-607 2439), 100% invested in UK prefs and corporate bonds, which aims for a combination of high income and long-term capital growth. But in our view, it's still too early to consider preference shares as a safe haven for income investors.
Published in How to invest
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David Stevenson
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