Preference shares can be source of regular income for fixed income investors in a falling interest rate environment
Synergee Capital Services
In past three years there are many reputed companies such as Tata Capital, L & T Finance Holding company, IL & FS, have issued preference shares under private placement. The dividend rate offered by them are very attractive for an investor, who are looking forward to fixed tax free return.
The preference share offers fixed rate of dividend till the maturity, and the dividend income is tax free in the hands of an investor. The shares can be freely traded like any equity shares. Tata Capital had issued their preference shares at 8.33%, with seven year maturity, whereas L&T Fin Holding and IL & FS offered dividend rate of 9 & 9.40% respectively in the year 2013.
As the above issues are offered under private placement, the retail investors are not aware about such investment option. Nor they can participate in the public offer of these instruments. But the shares can be purchased in secondary market via BSE/NSE terminal or in off-market transaction from an institution or a broking house. The price offered on the exchange/off-market, will have three variables (Face Value + Premium + Accrued Dividend).
Investors opting for fixed income instruments typically look for regular income. However changes in the tax rates, to be precise – increase in the tax rates, can be a big risk they are exposed to, as the income they receive may go down. To protect investors in preference shares below clause has been introduced by L&T Finance and IL&FS in the information memorandum of the preference shares issues.
Change In Tax Laws :- In the event of any change in applicable tax laws on account of which the dividend received by the compulsorily redeemable preference shares (CRPS) holders becomes subject to any tax to the account of the CRPS Holders, the company shall declare and pay such additional amounts as dividend such that the total amount received by the CRPS holders as dividend (“Aggregate Dividend Rate”) in relation to the CRPS less the tax payable on account of the change in applicable law is equivalent to the Rate of Dividend as set out above.
What the clause makes it clear that in case there is a tax introduced on the preference shares dividends, the company will raise the dividend declared on preference shares to such an extent that the in hand dividend will match the earlier committed dividend. This addresses one big risk faced by the preference shares investors.
Under falling interest rate scenario, preference shares offers very attractive rate of return on investments, as compared to other fixed income securities. For examples, TATA Capital NCD maturing in 2020 offers a yield of 9.20% whereas Tata Capital preference shares are available at 8.25% yield to maturity. Also a point to note is the interest on NCD is taxable whereas the dividend on CRPS is tax free.
However there are two issues one cannot totally ignore. First is the lack of ample liquidity in these preference shares. Since the issue size is small, there is no guarantee that you will get exit at fair value. In simple words, buy these instruments if you are comfortable holding them to the maturity. If you see a capital gain in the next one year and you get an exit at fair price, then it won’t be a problem. However, if it does not happen due to lack of liquidity, you should not repent on your decision of investing in these instruments.
Second is the provision that allows the preference share issuer to not pay dividend if the company does not make any profit in a particular year. Not that you have to forget the dividend for that year. It gets accumulated and paid later. Probability that the companies mentioned above will not have any profits to service preference share capital in a particular year is very low.
Depending on the tax slab you are in and the liquidity preferences, you may consider investing some money in preference shares.