Perpetual Preference Share Versus Five-Year Bond
A JSE-listed perpetual cumulative preference share has a par value of R100 and pays a fixed dividend of 8.50% of par semi-annually. It has just paid its semi-annual dividend and now trades ex-dividend at R92.50. The next dividend is due in 182 days. The issuer may redeem at par after five years. A corporate investor subject to 27% income tax on interest and 20% dividends withholding tax is comparing the preference share with a five-year plain vanilla bond yielding 9.75% to maturity. The investor expects the repo rate to remain at 8.25% for the next year and can reinvest preference dividends at 7.00% p.a. compounded semi-annually. The preference share's bid-offer spread is 0.75% and the bond is liquid. The investor's mandate permits perpetual instruments but limits exposure to any single issuer to 5% of the portfolio.
1. Calculate the current yield, pre-tax effective annual yield and after-tax effective annual yield at R92.50.
Read the worked answer
Annual dividend = 8.50% × R100 = R8.50, paid as R4.25 each half-year.
- Current yield = 8.50 / 92.50 = 9.19%.
- Pre-tax half-year yield = 4.25 / 92.50 = 4.5946%.
- Pre-tax effective annual yield = (1.045946)² − 1 = 9.40%.
- After 20% dividends withholding tax, net half-year dividend = 4.25 × 0.80 = R3.40.
- After-tax half-year yield = 3.40 / 92.50 = 3.6757%.
- After-tax effective annual yield = (1.036757)² − 1 = 7.46%.
The 9.19% current yield is not the same as the effective return because dividends are semi-annual and the purchase price is below par. The 0.75% bid-offer spread would reduce the achieved yield if the investor buys at the offer rather than at R92.50.
2. Compare the preference share's after-tax return with the bond and identify the main non-tax risks that could justify a yield difference.
Read the worked answer
Bond after-tax yield = 9.75% × (1 − 0.27) = 7.12%.
The preference share's after-tax effective yield of about 7.46% is roughly 34 bp higher. On tax alone, the preference share looks marginally more attractive. But the comparison is not like-for-like:
- The preference dividend is not contractual interest; it can be deferred if the issuer has insufficient distributable reserves, even though it is cumulative.
- The instrument is perpetual but callable at par after five years. If yields fall, the issuer is likely to call, capping capital upside; if yields rise, the investor is left with a long-duration instrument.
- The preference share ranks behind debt and may have limited liquidity.
- The bond has a known maturity and usually tighter bid-offer spreads.
A 34 bp pickup is thin compensation for subordination, call risk and liquidity. The investor should demand a larger spread unless the issuer credit is strong and the instrument fits the 5% issuer limit.
3. If the investor's required pre-tax yield rises to 10.50% compounded semi-annually, estimate the preference share price assuming it is valued as a perpetual annuity with no call. Why is this estimate imperfect?
Read the worked answer
With a required nominal yield of 10.50% compounded semi-annually, the half-year discount rate is 5.25%. The半-year dividend is R4.25.
Perpetuity value = (\frac{4.25}{0.0525} = R80.95).
That is about 12.5% below the current R92.50, showing meaningful duration sensitivity. The estimate is imperfect because:
- The issuer can call at par after five years, so the investor effectively holds a perpetual instrument with a cap on upside. If yields fall, price is pulled toward par, not to a higher theoretical perpetuity value.
- Credit spread, liquidity and the 0.75% dealing spread are not in the simple perpetuity formula.
- Dividends are discretionary in stressed conditions, even if cumulative.
For risk management, the investor should treat the preference share as long-duration credit exposure, not as a short-term cash substitute.