Sunday, 9 September 2012

Preference Shares

Preference shares are a special class of shares issued by companies to raise additional capital. They pay a regular, pre-determined dividend until the shares are called or bought back by the company. Unlike ordinary shares, they do not have voting rights or share in any profits of the company. In this regard, they bear greater resemblance to bonds rather than ordinary shares. Their share prices also do not fluctuate much, reflecting the fact that their returns (through the dividends) are fixed and regular, unlike ordinary shares whose returns can be affected by many factors.

Preference shares have been listed on the Singapore Exchange for more than 10 years, mostly issued by the 3 local banks of DBS, OCBC and UOB. In recent months, they have been joined by several non-financial companies such as Hyflux and Genting in issuing preference shares or perpetual bonds. This even caused MAS to sound an alert to banks and retail investors of the risks that these perpetual issues pose.

Despite being around for more than 10 years already, the market is still unclear how to price these preference shares, judging by the price discrepancy in some of the preference shares. Take for example OCBC, which has 2 tranches of preference shares, Class B which pays 5.1% annually and Class E which pays 4.5% annually.  The current share prices of the 2 tranches are $104.75 and $102.20 respectively. This means that for every $10,000 investment in the 2 tranches of preference shares, Class B will yield $486.87 ($10,000 / $104.75 x $5.10) while Class E will yield $440.31 ($10,000 / $102.20 x $4.50). Clearly, Class B yields more than Class E and this creates an arbitrage opportunity that should cause Class B shares to rise and Class E shares to fall until they reach equilibrium. As a matter of interest, what should be the correct price differential be? Assuming that both tranches of preference shares should yield 4.6% annually, the price of Class B would then be $110.87 ($5.10 / 4.6%) and the price of Class E would then be $97.83 ($4.50 / 4.6%), giving a price differential of $13.04 ($110.87 - $97.83).

However, this price discrepancy has existed for many years and shows no signs of correcting. In order for this price discrepancy to disappear via arbitrage, one has to buy Class B and sell Class E shares. Likely, there are no Class E shares available for short-selling, leading the price discrepancy to exist till today. Let's see when will the price discrepancy corrects itself.

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