Preference shares depict features of bonds when one looks at risk-return profile.
The term preference share evokes mixed reactions in terms of the risk-return profile, and is perceived as a ‘hybrid’ kind of investment. Though technically it is a share, in terms of risk-return behaviour, these are suitable for fixed income investors. The reasons are (a) dividends are fixed, akin to coupon (interest) on a bond (b) there is a defined maturity, akin to bonds, since most preference shares in the market are redeemable, (c) they have a credit rating, similar to bonds and (d) secondary market volatility is limited and yield / price movement is in accordance with interest rate movement in the economy.
Let us now discuss the pros and cons of this investment avenue. The benchmark for comparison will be bonds of similar credit rating, as the risk-return profile is similar. One big advantage is the tax efficiency. Being technically in the nature of shares, and not bonds, dividends are tax-free in the hands of the investor. The company i.e. the issuer has to pay a dividend distribution tax (DDT). The only tax impact on investors is that the Budget of February 2016, applicable from 2016-17, provided that for investors receiving more than Rs 10 lakh of dividend per year, there would be a tax @ 10% on the dividend received. This is applicable on individuals and HUFs i.e. non-corporate assesses. Even for individuals receiving more than Rs 10 lakh of dividend in a year, preference shares are significantly more tax efficient over bonds. In a bond, the bulk of the returns come from coupon, which is taxable at the marginal slab rate which in most cases is 30% plus surcharge (as applicable) and cess (Click here to know more).
On the taxation aspect of preference shares, there is relief for non-corporate assesses in the form of ‘tax indemnity clause’ in the Offer Document, which means if there is any change in tax laws subsequent to the issue, the issuer will indemnify the investor to the extent returns have been impacted. The investor has to refer to the offer document to find out whether the clause is there. It reads something like “Change in Tax Laws: In the event of any change in tax laws as applicable at the time of allotment on account of which, the Dividend/ Redemption Premium received by the holder(s) becomes subject to any additional tax to the account of the holder(s), the Issuer shall declare and pay such additional amounts as Dividend/ Redemption Premium such that the total amount received by the holder(s) as Dividend/ Redemption Premium less the tax payable on account of the change in applicable tax laws is equivalent to the Rate of Dividend as has been set out”.
The disadvantage of preference shares is the lack of liquidity in the secondary market. For unlisted preference shares, secondary market sale can be done only in known circles, where price discovery would be an issue and it would be an off-market transaction. In listed preference shares, since trades don’t happen every day, purchase or sale has to be executed through a few bond dealing houses who trade in preference shares as well. The lot size in those customized deals would be suitable for high networth individuals and from that perspective it is not a retail investment product. In the bond market, secondary market liquidity for bonds rated less than AAA is an issue, hence these two investment avenues are on a similar plane.
We will look at the options available to investors to take exposure in this product. New issues being few and far between, let’s look at the ones currently available in the secondary market.
Indicative List of Preference Shares Available in Secondary Market
Data Source: Phillip Capital India Fixed Income Desk
For comparison between yields of preference shares and bonds, we have to look at the ‘pre-tax equivalent’. Assuming bonds are taxable at 30%, we have to find out the approx comparable level for a preference share, which is tax free. Taking a yield of 7.2% for a preference shares and taxation efficiency at 30% i.e. bond taxation at 30% and preference share taxation at zero, the comparable yield on a preference share is 7.2% / (1-30%) = 10.28%. The comparable level at taxation efficiency at 20% i.e. bond taxation at 30% and preference share taxation at 10%, is 7.2% / (1-20%) = 9%. This is much more attractive than yield levels available in bonds with a similar credit rating.
To conclude, investors can allocate a part of their fixed income investments to preference shares, keeping the liquidity issues in mind. Best scenario is, if you can match the maturity of the instrument with your cash flows, thereby doing away with interim liquidity requirements.