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By Nick Downing*
In general, people take far too little risk in their investment careers, even when generating income. The conventional wisdom is that an income portfolio should lie at the low end of the risk spectrum. The starting point in structuring the portfolio is mistakenly risk rather than return. As a result, these portfolios gravitate towards ultra-low risk and ultra-low return instruments such as money-market funds, which currently yield a paltry 3.5%, even less than the rate of inflation. The nominal return is 3.5% but the real return after taking the 5.0% inflation rate into account is 5% less 3.5%, which equals -1.5%. Financial advisers and their clients tend to be too fixated on risk, which often results in too little spending power in the retirement years.
Preference shares have provided excellent income returns for investors since they were first listed on the JSE in the mid-2000s. Although they count as equity they have debt like characteristics, paying a yield linked to the prime rate, and are ahead of ordinary shares in terms of seniority. Preference shareholders must be paid out in full first before any dividends can be distributed to ordinary shareholders.
Over the long-term, preference shares have outstripped both bonds and cash. A year ago, due to pandemic risk aversion, preference shares were trading at record low levels with pre-tax yields well above 10% in some cases. The valuation anomaly has since been corrected and prices have surged over the past 12 months. There has been a double whammy, both attractive dividend income as well as substantial capital growth. In some instances, prices have surged over 50%. Adding fuel to the rally, some of the preference shares have been redeemed by their issuers as they were considered too costly. The banks specifically are anxious to redeem what they now consider to be an expensive form of debt. Changes in banking regulations mean banks can no longer count preference shares as part of their primary capital. So far this year, preference shares have already been redeemed by PSG and Sasfin. Nedbank and Investec are in the process, with offers already posted to shareholders. The flipside of preference share capital being too costly for the issuer is that it provides excellent value and an important source of income for investors.
Other preference share issues will also be redeemed. This ought to create an additional uplift to preference share prices, but financial markets are forward looking and much of this upside has already been discounted. As prices have firmed so the yields have compressed, providing less value for investors. With the redemptions, the preference share universe is also shrinking, which is regrettable for investors.
The pre-tax yields on the bank preference shares have compressed significantly over the past 12 months. With the Nedbank preference shares, for instance, the yield has dropped from over 9% to just over 6%. Meanwhile, the ordinary shares trade on an estimated 12-month forward dividend yield of over 7%. The risk might be higher as ordinary shares are lower than preference shares on the pecking order of capital seniority, but unlike ordinary shares, preference shares have the potential to grow the dividend over time in line with rising profits. At this point, it makes sense to switch the Nedbank preference shares for Nedbank ordinary shares.
There are many shares that pay ordinary dividend yields that beat the money market rate. Bank shares and commodity shares pay dividend yields of 5% or more. Real estate investment trusts (REITs) also pay attractive yields, which hold the potential of growing over time. REITs have suffered a tremendous knock as shopping malls and offices emptied over the pandemic and are still at depressed levels, but the cheap share prices provide upside in terms of both yield expansion and capital growth. Growthpoint, the country’s largest REIT with a market capitalisation of R45 billion, trades on an estimated 12-month forward yield of 10%. Even if the forward estimate is wildly optimistic, the yield would still in the worst-case scenario be comfortably above the money market yield and inflation rate.
Despite their dramatic re-rating, some of the non-bank preference shares still offer compelling value, with pre-tax yields of around 8% in the case of the Discovery, Grindrod and Netcare. With their yields linked to prime, income will increase in line with rising interest rates, unlike conventional bonds which pay a fixed coupon and therefore offer no protection against interest rate risk. Preference shares also hold tax advantages. Their yields incur a 20% dividend withholding tax rather than a maximum 45% interest income tax, which is the rate levied on bonds and REITs.
Nonetheless, investors can look confidently to the bond market as an alternative and complimentary source of superior income yields. South African government bonds pay amongst the most generous income yields in the world. The 10-year government bond pays a yield of 9.40%, a whole 4.4% above the inflation rate and almost 6% above the money market rate.
A long-term investment strategy is traditionally reserved for growth-oriented portfolios, but investors should adopt a similar time horizon when planning for their income needs. A share in profit growth (ordinary shares and REITs) is vital for keeping up with inflation. Where fixed yields are concerned, there are far superior alternatives (preference shares and bonds) to money markets. Money markets play an important role, for holding cash that is already budgeted, but should never play a pivotal role in a long-term portfolio. It is advisable to contact your personal advisor or asset manager before structuring a long-term growth-oriented income portfolio. Such a portfolio should be professionally structured and actively managed.
*Nick Downing is the CEO and CIO of Overberg Asset Management.
- All writers’ opinions are their own and do not constitute investment recommendations or financial advice. Speaking to a qualified wealth and investment professional is crucial before making financial decisions.
- ‘Overberg Asset Management (Pty) Ltd. is an authorised financial services provider: 783’.
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