Preference shares: an endangered species?

"10-15 years ago, banks would have raised tier 1 capital through preference shares, these days they tend to choose hybrid capital," says Ron Plumstead, a preference share consultant to Evolution Securities. Tier 1 capital is vital to banks, as under the Basel rules it can be depleted without putting banks into insolvency. Ordinary share capital fulfils that role perfectly, but is expensive. Hybrid capital, such as the enhanced capital notes issued by Lloyds, achieve that goal more smoothly by explicitly specifying the conversion risk to investors and the circumstances that would trigger it.

By contrast, the situation with preference shares remains less clear. "Over the past few years the goalposts for preference shares have been moved by the European Union and governments over the circumstances in which coupons on preference shares should be paid," says Mr Plumstead. EU rulings on state aid to insolvent banks such as Bradford & Bingley and Northern Rock have complicated the issue.

Mr Plumstead notes that it wasn't just accidental that preference shares continued to be traded in the names of subsidiary entities. He says that his understanding is that a profitable subsidiary would still have to pay a coupon on a preference share, even if it was part of a loss-making larger group that had passed its dividend, in order for the subsidiary's profits to be added at group level. However, a loss-making subsidiary in a profitable group could pass on its preference share coupons for the same reason, he adds.

How this will be affected by any potential regulatory separation of banks into utility banking and risk capital units remains to be seen. However, so long as banks intend to return to paying ordinary dividends, the patient preference shareholder will not be ignored.

Enhanced capital notes

A number of preference shares have in the past year become enhanced capital notes (ECNs), a hybrid security that is contingently convertible (hence the name CoCo) based on an outside event, which will turn them into ordinary shares. Theoretically, they rank ahead of ordinary and preference shares, and perpetuals, although it should be borne in mind that the circumstances leading to a liquidation would almost certainly lead to a conversion beforehand.

Almost all the listed ECNs are in Lloyds Banking Group, which swapped them for all its various classes of preferred stock late last year in fairly controversial circumstances. For Lloyds, they allow the bank to reorganise its capital should its tier 1 capital fall below 5 per cent. The chance of this happening would of course be the central preoccupation of its ECN holders. There are also ECNs trading in Chelsea Building Society since its merger with Yorkshire Building Society. Some £200m of subordinated notes issued by Chelsea were converted into £100m ECNs in Yorkshire under the terms of the rescue merger. These, like Lloyds' ECNs, will convert on a 5 per cent tier 1 capital breach, but into profit-participating deferred shares, a building society equivalent of ordinary shares. ECNs are dealt 'clean' of interest, like bonds, so purchases are settled separately of the interest owed.

Finding preference share data

Although there isn't much specific preference share research available to private investors, the fact that most issuers are quoted companies gives an important advantage over Pibs. While there is little news emerging about the solvency of the average building society between annual reports, and the occasional rating change, most companies that have preferred issues outstanding also have hefty ordinary share analytical and press coverage. Clearly, so long as the ordinary dividend looks safe, then the preferred dividend is safe, too.

Prices can be problematic, though. Collins Stewart issues a weekly table of prices and yields for the most popular issues at collins-stewart.com/ServicesProducts/FixedInterest.asp.

Real-time prices can, however, be patchy. Very few of the automated company search tools at online brokers throw up more than a small proportion of the preference shares available, so it is as well to speak to your broker. A few calls by your broker to a market maker may well throw up many more opportunities. It is also worth emphasising that, while many of these issues are quoted at a fat bid-offer spread of up to 10 points, it is quite often possible to deal within it if you set a limit and are patient.

If your broker knows you might be interested in a reasonably sized investment, then it is quite possible to get a better deal. None of the quotes are immutable. For investors, though, it is the big financial companies and legacy issues from banks and utilities that make up the lion's share of the market, and where they can get the best liquidity and value, and clear pricing.

Aviva has the only UK managed pref-share fund, yielding 5.3 per cent and with a total expense ratio of 1.37 per cent and a 4 per cent initial charge.

Those willing to look overseas will find both an active market for preference stocks in Canadian firms on the Toronto Stock Exchange, and an exchange-traded fund from Claymore based on them. Powershares also has a US ETF tracking prefs.

Six preference shares that offer good value