The Quest for Income in a Low-Interest Economy: Preference Shares
With interest rates recently cut to a record low of 0.25% in order to prevent the economy sliding into the post-Brexit doldrums and further cuts predicted, many investors are seeking to top up poorly performing pensions or improve upon the meagre returns achieved by their savings.
Investing for income, sometimes ‘income investing’, is any investment that can generate a cash income in the form of dividends or interest payments.
When applied to equity income investing this can mean looking for companies that pay regular and reliable dividends; the compounding effect of reinvesting these dividends can deliver solid long term returns.
A source of predictable income are ‘fixed-income’ products, where the investor loans money to the government (gilts) or a company (corporate bonds) and in return receives guaranteed interest payments (coupons) for the duration of the loan; the size of the coupon reflects the level of risk that the borrower will not be able to repay the loan.
Income investors attracted by the dividends that can be generated by shares, but reassured by the certainty of bonds, may consider a lesser known investment – preference shares – which offer some of the highest yields available to the DIY investor.
Preference shares, or ‘prefs’, are a hybrid between an ordinary share and a corporate bond, and may represent an attractive opportunity for investors willing to spend a little time getting to grips with them.
Along with shares and corporate bonds, preference shares are another way in which listed companies raise money, but they differ in terms of the rights an owner has in terms of being paid an income, and what happens if they are not.
Preference shares are listed on the stock market, like ordinary shares, but differ in that they pay holders a fixed dividend, usually twice a year, just like the coupon paid on a bond.
‘a hybrid between an ordinary share and a corporate bond’
In order to compare investment opportunities, analysts consider its ‘running yield’ which is the annual income of a share or bond divided by its market price.
Bonds are issued at 100, or ‘par’ and pay a fixed percentage of that figure as an annual coupon; a 6% bond would therefore pay £600 on a £10,000 investment every year until the end of the agreed term of the loan.
However, if demand for that bond were to push its price up in the secondary market, an investor buying it at 110 would see the effective yield diluted to 5.54% – 6/110.
In the same way, the dividend achieved from a preference share will vary according to the price paid for it in the open-market and because of the attraction of the dividends they deliver, many trade at a price that depresses the effective dividend that is paid.
Preference share holders have the right to be paid before any ordinary dividends can be paid, and this fixed income may be an attractive alternative to the fluctuating dividend payments from ordinary shares.
As with all fixed income products, the value of the dividend in real terms will be eroded by inflation over time and the price of the preference share fluctuates with interest rates and inflation.
This is a key difference between preference shares and ordinary share dividends, which tend to increase over time meaning that ordinary share prices can continue to grow indefinitely.
In order to address this issue a recent development has been the creation of both bonds and preference shares that deliver returns linked to a particular index or measure of inflation to ensure that its effective dividend is not eroded.
There are other key differences between the rights bestowed upon their owners by issuers of preference shares and bonds; if bondholders don’t receive their interest, they can bankrupt the company, but preference shareholders do not wield the same power and prefs are junior to all other company debt such as debentures, bank debt and loan notes.
‘they pay holders a fixed dividend, usually twice a year, just like the coupon paid on a bond’
If a company is unable to pay its dividend in a particular year, preference shares are cumulative and must be paid in full if and when the company is subsequently able to; however, if the company were to go bankrupt, you’ll never get your lost income.
In such an eventuality, preference shares rank ahead of ordinary shares in terms of the company’s capital structure – but behind bondholders – although when ordinary shares become worthless, preference shareholders get nothing and even bondholders seldom get all their money back.
Dividends are paid out of taxed company profit, so for the purpose of tax, preference shares are treated the same way as ordinary dividends, meaning that they are paid net – basic-rate tax payers have no more tax to pay on their income, while higher-rate taxpayers are effectively taxed at 25%.
Those seeking income may appreciate the security of having to be paid a dividend before ordinary shareholders – and cumulative payments if you’re not paid; investing in this special share class is more about getting a slightly better income, in return for forgoing the chance of equity-like gains.
Most preference shares are undated, but some have a final redemption date, so care must be taken when considering the redemption yield, but overall preference shares can deliver a permanent flow of income at a yield that is likely to hold its own against inflation.