DIY Investor Magazine
/
September 2016
12
DIY Investor’s Stephen Haysom introduces this hybrid
of ordinary shares and bonds
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
THE QUEST FOR INCOME IN A LOW-INTEREST
ECONOMY: PREFERENCE SHARES
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. 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 shareholders 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.
AREHOLDERS HAVE THE RIGHT TO BE PAID BEFORE
ANY ORDINARY DIVIDENDS’
PREFERENCE SHARES CAN DELIVER A PERMANENT
FLOW OF INCOME
