Sunday, 29 May 2016

Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form

I have been investing in preference shares (prefs) for many years, so much so that I had forgotten that as an investment form, prefs are actually inferior to stocks and bonds. In fact, prefs have been the cornerstone of my equity-centric investment strategy, saving my equity portfolio during severe market crashes, as described in Behind Every Successful Bear Market Recovery is A Cash-Like Instrument. It was only last week when Hyflux launched its IPO of perpetual capital securities (perps) that I looked into the features of perps and remembered that prefs and perps (which are similar in nature to prefs) are inferior to stocks and bonds as an investment form. 

Just to recap the characteristics of prefs and perps, they are perpetual securities with no redemption dates and hence are considered some form of equity. Unlike stocks, they have a pre-determined dividend/ distribution rate (distribution shall include to mean dividend for prefs and interest payment for bonds henceforth). However, the actual payout of the distribution for prefs and perps is discretionary, which means that the company can choose not to pay the full amount of distribution at the pre-determined payout date. For cumulative prefs and perps, any distribution not paid will accumulate and be paid out in the future (again, at the discretion of the company). Unlike bonds, this deferral of distribution is not considered a default event.

Compared to bonds, prefs and perps are inferior for several reasons. Firstly, payout of the stated distribution rate is not guaranteed and is not considered a default event. Secondly, if a company misses a bond interest payment and is unable to remedy it within a given period of time, the entire bond issue becomes redeemable immediately. If the company is unable to redeem its bonds, the company will go into default. Not only that, the company might have some loans with cross-default covenants stating that if the company defaults on some other loans or bonds, that particular loan will also become repayable immediately. In other words, when one creditor descends on the company, all other creditors will also quickly do so to safeguard their own interests. Thus, the company will be very careful not to default on any of its loans and bonds. For prefs and perps, there are no similar chain reactions since deferral of distribution is not considered a default event. Thirdly, in the event of claims, bonds rank higher than prefs and perps. Thus, bondholders have priority claim over pref and perp holders. 

Thus, for the above reasons, prefs and perps are inferior as an investment form to bonds. To compensate for the higher risks of prefs and perps, the margin of safety for investing in them needs to be higher. If you refer to The Lost Art of Bond Investment, you will see that the margin of safety required for Benjamin Graham's 2 criteria of minimum average earnings coverage and minimum current stock value ratio is higher for prefs than for bonds.

Compared to stocks, prefs and perps are also inferior for several reasons. Firstly, the upside is limited to the stated distribution rate for prefs and perps but unlimited for stocks. In my opinion, this makes for an unfavourable upside/ downside ratio for prefs and perps. Consider a pref with a stated distribution rate of 5%. If nothing goes wrong, you get a maximum of 5% in distribution every year. But if something goes terribly wrong, you can lose up to 100% of your capital. For stocks, it is also possible to lose 100% of your capital, but the capital gains (if any) for such high-risk stocks are usually more than 5%. Secondly, stocks have voting rights, but prefs and perps do not. If the current management is not doing a good job, stockholders can band together and vote out the current management. Pref and perp holders do not have such rights. Thirdly, the trading liquidity for stocks is much higher than that for prefs and perps. If you do not think the company is doing a good job, you can just sell and go away. However, for prefs and perps, there might be insufficient liquidity to sell at a reasonable price quickly. 

Thus, the worst possible scenario for prefs and perps is that the company defers some parts of the stated distribution and the price declines to reflect the uncertainty in timeline of the distribution, but you cannot get out because the company has no obligations to redeem the issue and the liquidity is too low for selling at a reasonable price.

In conclusion, as an investment form, prefs and perps are generally inferior to stocks and bonds. However, individual prefs and perps may have their own investment merits. Investors need to assess for themselves whether individual prefs and perps are good investments. 


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2 comments:

  1. Hi Chin Wai,

    Thanks and I tend to agree with you. But there is an argument that prefs n perps of DBS and OCBC are somewhat guarantee with unwritten rules.

    Some people say before that if DBS is ever to not pay her coupon for one time, then it virtually means the whole Singapore is on verge of collapse!

    I disagree with the above, bcos in crisis that may be worse than GFC DBS have the rights to miss their coupon, while Singapore as a country is still intact. Just that we always gauge history as future.

    What do you think? If DBS or OCBC miss their payments for prefs n perps, does it nec means they will be gg bankrupt?

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    1. Hi Rolf,

      I agree with you. If DBS were to fall into financial difficulties, Temasek would try to save DBS, but it won't jeopardise itself in doing so. If DBS cannot be saved, then it has to be let go. NOL is a recent example that Temasek has let go without expending further resources to keep it afloat.

      Anyway, prefs and perps are structured such that even if the company misses a payment, it won't go into default ;) So, they help to prevent the company from going bankrupt.

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