Dear investors,

Since their introduction in around 2004, preference shares (“prefs”) have provided investors with high-yielding equity (even though they look and act like debt) instruments linked to the prime interest rate, which is currently 10.5%. This has been a very attractive option relative to cash and bonds for income seeking investors, but the environment is changing thanks to legislation (called “Basel”) around the capital structure of banking institutions.

Since 2013 preference shares counting as Tier 1 capital for banks has been reduced by 10% per annum (i.e. for a R1bn issue in 2014, only R900m will count the following year) which has made preference shares progressively more expensive for banks to hold, as the portion not counting has to pay pref dividends from after-tax profits! Banks are thus highly incentivised to purchase back their own preference shares at a rate of 10% per annum or more if the price is attractive relative to par (the issue price).

Remember, the banks can book a profit (issue price – current price) on the repurchase of prefs at a discount to their issue price (or par value). A further incentive if there ever was one! Brait redeemed their entire pref issue in January 2016 at the deemed issue price of R100 per share plus accrued dividends at that date. Who is likely to be next?

Investec Preference Share (INPR):

Investec announced at the beginning of this month that it was planning to raise GBP145m (approximately ZAR3bn) by selling equity to buy back their preference shares and are expected to pay investors holding INPR R100 + accrued dividends. Now this is all well and good for investors booking a profit but the dilemma remains. What to do with the proceeds? The table below shows the annual income reduction facing an investor (per R1m invested) with a 35% tax rate on interest income proceeds vs 15% tax rate on pref dividends.

Annual after-tax income difference on Investec prefs vs Investec high income unit trust fund

This poses a problem for income seeking investors and introduces an interesting challenge for Cordatus when it comes to advising new investors and existing clients with material preference share dependence.

Over the next few years we see the discussions we will be having with new and existing investors being framed as follows;

  • The rate of pref buy-backs by banking institutions & impact on portfolio risk & income.
  • The inclusion of high-yielding (short duration) debt up to age-dependent tax thresholds.
  • Larger SA listed property allocations (not offshore due to FX matching of liabilities) for income purposes, inflation protection and income growth.
  • The inclusion of prefs with differing credit (eg PSG, Grindrod) and liquidity profiles.