Preference Shares: Fixed-Income Equities
What the exam tests
Preference shares sit between debt and equity, and the exam tests that hybrid character: ranking in the capital structure, dividend mechanics, call features and how the price behaves when yields move.
Core rules
- Preference shareholders rank ahead of ordinary shareholders for dividends and on liquidation, but behind all creditors. Dividends are only paid if declared.
- Cumulative preference shares roll unpaid dividends forward as arrears; non-cumulative shares lose them. Participating shares take an extra slice after ordinary dividends reach a stated level.
- The dividend is a dividend, not interest. It is paid from after-tax profit, is not tax-deductible for the issuer, and attracts dividends tax at 20% in the hands of a non-exempt South African holder.
- Many SA listed prefs are variable-rate perpetual instruments issued by banks, paying a floating rate linked to prime (for example, prime less a margin). Others are fixed-rate with a call or step-up date.
- Because the coupon is fixed or formula-linked, the price moves inversely to required yields, like a bond. A perpetual is valued as a perpetuity: price = dividend / required yield.
Worked example: valuing a perpetual preference share
A preference share with R1,000 nominal pays a fixed 8.5% dividend, so R85 per year. Your required yield is 9.5%.
- Price = 85 / 0.095 = R894.74
The share trades at a discount to nominal because the coupon is below the market yield. If yields fell to 8.0%, the price would rise to 85 / 0.08 = R1,062.50. That sensitivity is the whole point of the instrument for a portfolio manager.
Traps that cost marks
- Treating the preference dividend as interest and deducting it before tax.
- Forgetting the call feature: a fixed-rate pref trading above par that can be redeemed at par caps your upside.
- Assuming a prime-linked pref has a fixed rand dividend; the cash amount resets with the reference rate.
- Ignoring arrears when valuing cumulative prefs in distress.