Preference shares their place within an income portfolio

Transcription

1 Preference shares their place within an income portfolio Disclaimer General disclosures This research is commissioned by our clients and only released for general circulation with their permission. This research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. Research reports are published at irregular intervals as appropriate in the analyst's judgment. The date of this report is shown at the bottom of the page. We and our affiliates, officers, directors, and employees will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual readers. Readers should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.

2 Preference shares their place within an income portfolio Aims of the analysis Identify the benefits and risks of preference shares as an investment asset sub-class within an income focussed share portfolio. Overview of preference shares Preference shares are issued with a fixed par value and pay dividends based on a percentage of par at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. Preference Shares are usually undated, like perpetuities or they may be called by the issuer after a certain date like callable bonds. The company generally calls securities that pay higher rates than those the market is currently offering. Like bonds, Preference Shares are senior to common stock. However, bonds have more seniority than Preference Shares. The seniority of Preference Shares applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. If the business is wound up, and there is any capital left over after paying the various creditors, preference shares are repaid before ordinary shares. Preference shares usually have no voting rights. Types (Non-)Cumulative: If the company withholds part, or all, of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Most UK preference shares appear to be non-cumulative. Irredeemable/Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus. However a number are irredeemable and these should be viewed as undated gilts. Convertible: The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus. Participating: If the company issues participating Preference Shares, those stocks gain the potential to earn more than their stated rate. The formula for participation will be found in the prospectus. Adjustable-Rate Preferred Stock (ARPS): Dividends for ARPSs are tied to yields on government issues or official rates, providing the investor limited protection against adverse interest rate markets. 1 of 8 27 January 2014

3 Payments Unlike bond interest failure to pay a preference dividend cannot force the company into administration. Some preference shares are 'cumulative'; this means any preference dividends not paid will be accrued until funds are available, and must be paid out in full before ordinary shareholders receive anything. Current Yields Table 1 shows the range of rates on some of the preference shares currently outstanding. They range from 5.6% up to 13.2%, with most yielding in the high 6% range. Set against this are 10, 30 year and undated gilts yielding 2.25%, 3.25% and 4.3%. Table 1 Preference Share Rate Co-op 9.25% Prefs 13.2% Santander % 8.2% Santander 8.625% Prefs 7.8% R.E.A Holdings 9% Net Cum 7.8% Lloyds 9.25% Prefs 7.5% Lloyds Banking 9 1/4% Net Non-Cum 7.3% Bristol & West 8.125% Prefs 7.3% Lloyds Banking 9 3/4% Net Non-Cum 7.3% Ecclesiastical Insurance 8.625% Prefs 7.2% NatWest 9% Prefs 7.2% General Accident 8.875% 7.0% General Accident 7.875% 6.8% Aviva 8.75% Prefs 6.6% Sun Alliance 7.375% Prefs 6.6% Aviva 8.375% Prefs 6.5% Tate & Lyle 6.5% Cum. Prf. Â 1 (BD15) 6.4% Lewis Php.7Hpf 7 1/2% Cum Prf Stk #1 (BD32) 6.3% Standard & Chart 8.125% Prefs 6.2% Lloyds 6.475% Prefs 6.2% Lloyds Group 6.475% Non-Cum (2024 Call) 6.2% Bristol Water 8.75% 6.0% Standard & Chart 7.375% Prefs 5.6% N Elec 8.061% Prefs 5.6% BP 8% Cum 1st Prf (BP.A) 5.6% Lewis Php.5%Pf 5% Cum Prf Stk #1 (BD45) 5.6% 2 of 8 27 January 2014

4 Sensitivity to interest rate changes If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds. Liquidity Risk The shares tend to be held by institutions and may not be particularly easy to buy or sell depending on the issuer. Bid-Offer Spread Looking at Lloyds Banking Group 6.475% Non-Cum Pref Shares (LLPE) we see similar spreads quoted across different brokers. Hargreaves Barclays DigitalLook Lansdown Buy Sell Spread % of buy price 3.8% 3.8% 3.8% Tax treatment Tax treatment: As with ordinary shares, buyers of UK-listed preferred shares pay 0.5% stamp duty. The capital and income tax treatment is also the same as for shares, so they tend to be deemed paid net of a 10% dividend tax credit. Wrappers Most UK-listed preference shares are eligible to be held in an ISA or SIPP. Diversification A large number of preference shares are issued by banks and financial services companies so diversification is hard to come by. 3 of 8 27 January 2014

5 Valuation of Preference Shares Where the shares have no call date and every dividend is the same the preference shares can be valued as a perpetuity with r as the required rate of return: V = D r Where there is a call date and or the dividend can fluctuate it is sensible to use a discounted cash flow model with a required return to establish the value of the preference share. Factors affecting price are interest rates, the company s financial performance and company credit ratings. Relative valuation Work by (Scapell, 2013) suggests yields relative to other fixed asset instruments may be a good relative measure, for example in Figure 1 they show US 10 year treasuries yield is only 50% that of preference shares. This could offer a reasonable benchmark for UK securities and suggests preference shares yielding over 5.5% may start to offer value dependent upon the issuer and terms. Figure 1 Work by Piper Jaffray suggests preference shares pay dividend and typically yields two to four percentage points higher than dividend yields on common stock of the same issuer. 1 1 PiperJaffray: PREFERRED STOCK:STOCKS THAT ACT LIKE BONDS 4 of 8 27 January 2014

6 Impact of rising interest rates Non-redeemable preference shares are likely to behave like undated gilts in response to rate changes (ignoring credit risk issues). Callable preference shares will have a duration that can be calculated and used to assess the impact of each 1% rise in base rates. Floating rate preference shares should generally offer protection against rate changes however the prospectus will need to be carefully examined to see if there are any limitations on rate adjustments. Information sources Some pricing and prospectus data can be gathered from: A larger range of preference share can be found on: Generally preference share prospectus are harder to find than annual accounts. Pros Higher fixed-income payments than bonds or common stock Lower investment per share compared to bonds Priority over common stocks for dividend payments and liquidation proceeds Greater liquidity than corporate bonds of similar quality Cons Callability may lose your income stream Lack of specific maturity date makes recovery of invested principal uncertain Limited appreciation potential, no tangible benefit from company growth. Interest rate sensitivity Lack of voting rights Conclusion Preference shares offer income opportunities that have to be set against the risk the dividends can be missed and the greater risk of capital loss. They look likely to be good candidates for inclusion into a portfolio when interest rates are considered to have peaked. 5 of 8 27 January 2014

7 Companies with good cash flow and a strong track record of paying their dividends make the best candidates. Appendix 1 is the template that has been constructed for the evaluation of individual securities. It has been completed using the Lloyds Banking Group 6.475% Non- Cum Pref Shares (LLPE). References Scapell, W. (2013). When Interest Rates Rise. Cohen & Steers. 6 of 8 27 January 2014

8 Appendix 1 Preference Share Evaluation Template Evaluation criteria for preference shares issued in the UK Date of review: 22/01/2014 Name Lloyds TSB 6.475% Preference Shares Coupon 6.475p per 1 Par 1 Payment dates Semi-annually in equal instalments in arrears on 15 March and 15 September. Type Non-cumulative non-redeemable. Yield at review 6.348% Net real yield at review 6.195% (after SDRT and at 1.04 bid price) Duration Perpetual. Though Tax position Tax deducted at source and considered taxed at basic rate. ISA and SIPP will only guard against any further tax deduction or a capital gains charge. Issuer Governing laws Issuer credit ratings SDRT is charged at 0.5%. Lloyds Bank plc Scotland Redemption provisions Dividend history Dividend withholding criteria Seniority However, all or some only of the Preference Shares are redeemable, at the option of the Company, subject to confirmation from the FSA that it has no objection to the redemption (if required), on 15 September 2024 or any Dividend Payment Date occurring on the fifth anniversary thereafter at the Redemption Price per Preference Share. Payments were recommenced on the 15 March 2012, and since then all payments have been made. The Board of Directors or the Committee may in its discretion decide that a dividend will not be declared at all or will be declared only in part even when distributable profits are available for distribution. Holders of Preference Shares will rank in the application of the assets of the Company available to shareholders; (1) equally in all respects with holders of the most senior class of preference shares and any other class of shares of the Company in issue or which may be issued by the Company which are expressed to rank equally with the Preference Shares and (2) in priority to the holders of any other share capital of the Company (including the Junior Share Capital). 7 of 8 27 January 2014

9 Special terms Subject to the Articles, the provisions of the Companies Act and all other laws and regulations applying to the Company and to confirmation from the FSA that it has no objection, the Company may substitute the Preference Shares in whole, but not in part, with Qualifying Non-Innovative Tier 1 Securities, at any time without any requirement for consent or approval of the holders of the Preference Shares. If applicable law permits, the rights, preferences and privileges attached to the Preference Shares may be varied or abrogated only with the written consent of the holders of 75 per cent. In nominal value of the outstanding Preference Shares or with the sanction of an extraordinary resolution passed at a separate class meeting of the holders of the outstanding Preference Shares. Vulnerability to rate rises The security should be viewed as a perpetuity, though there is an argument that the 2024 redemption option does make this potentially a callable share. Assuming a required rate of 7% then the target price would be Relative valuation The spread over the 3.5% War Loan has narrowed to its lowest since Much of this is due to the recommencement of dividends after the EU prohibition. 8 of 8 27 January 2014