Preferential treatment – income alternatives

Figures from Link Asset Services bear this out. Through the fourth quarter of 2019, the leading five dividend payers were responsible for 34 per cent of the total amount returned to shareholders. That percentage has ranged between 32 and 44 per cent over the final quarter of the past five years, during which time the leading five positions have been shared by just seven companies. The next 10 largest payers have contributed an average 27.8 per cent of fourth-quarter dividends over the same period.

It’s a relatively narrow field given the sums involved. And with so many companies’ accounting years closing out on 31 December, the second and third quarters of any given year collectively make up around two-thirds of annual distributions.

This year promises to be a little different, as a third of the 15 top dividend payers have either deferred, or have been forced to cancel planned distributions. UK banks have been compelled to shelve their dividend plans after the Bank of England (BoE) Governor, Andrew Bailey, said that the interests of customers should be prioritised over those of shareholders.

Under the circumstances, who could blame him? Most eurozone banks also cancelled or suspended their dividends following pressure to do so by the European Central Bank and the European Banking Authority. The problem is that the banking sector is second only to oil & gas in terms of aggregate annual payouts – it’s not an easy hole to fill. Dividends from the sector made a significant contribution to overall growth in Q419, rising by a third year on year.

HSBC’s (HSBA) dividend alone is worth in excess of £3.6bn, out of a total of £98.5bn that was paid out to UK shareholders through 2019. It had been due to pay another $0.21 (£0.17) a share dividend on 14 April. It’s the first time that ‘the world’s bank’ has cancelled its dividend in 74 years, so the involvement of regulators must have irked some insiders, especially considering that HSBC didn’t require a bail-out at the time of the global financial crisis. Indeed, a recent article in the Financial Times suggests that the enforced decision didn’t play well with some board members, giving rise to speculation that the bank might move its headquarters from London to Hong Kong, where it derives over half its earnings – but why not Bogota or Mexico City on that basis?

The UK oil majors would also be loath to curtail or reduce their payouts, particularly Royal Dutch Shell (RDSB), which views its quarterly distributions almost as an article of faith. Unfortunately, the Anglo-Dutch giant and its stablemate BP (BP.) might have to forget about boosting their cover ratios with crude oil trading at around $25 a barrel.

The good news for shareholders is that the UK oil majors, which currently offer dividend yields of 10.6 and 9.6 per cent, respectively, have been willing to fund distributions out of debt when there have been free cash outflows, with the exception that BP felt impelled to halt dividend payments following the Deepwater Horizon disaster. A recent note from Goldman Sachs highlights how reluctant the oil majors have been to curtail payments, noting that Shell, ExxonMobil (US:XOM), Total (Sp:FP) and Chevron (US:CVX) have not cut shareholder payouts in 30 years.  

On the debit register, we can probably kiss goodbye to any special dividends this year. These were worth around 10 per cent of the aggregate payout in 2019, following weighty returns from mining heavyweights BHP Group (BHP) and Rio Tinto (RIO).

The trouble is that bosses might be more reluctant to sanction these one-off payments even when the economy returns to some semblance of normality. It’s nailed on that corporations will be reassessing their risk management policies to take account of any prospective lockdowns in the future. This could mean that they will become more conservative in their approach to share-based returns. It’s even conceivable that the government will implement capital adequacy regulations governing a range of industries beyond the banking sector. Any form of government intervention is likely to have negative implications for income seekers, so it’s worth examining alternative options.

It wouldn’t have gone unnoticed when the BoE put the kibosh on bank dividend payments that this didn’t extend to the interest on preference shares. Admittedly these securities, which have certain characteristics in common with high-yield bonds, are often overlooked, a relic of a bygone age, even though, by comparison, they aren’t as volatile and come with lower credit risk.  

The last time they made a splash on the financial pages was the widespread coverage of the public backlash that followed Aviva’s (AV.) attempt to cancel £450m-worth of its high-yield preference shares in 2018.

Shareholders claimed that they were unaware that the shares could be redeemed and were angry at being offered the £1.00 par price for every share, even though they had usually traded at a sizeable premium – unsurprising given that yields on preference stock are usually, under normal circumstances, well in advance of those available on common stock.

When news of the Aviva plan broke, prices for many other preference shares clicked into reverse. Eventually, the insurer backed down – partly due to institutional shareholder pressure – and Andrew Bailey, then chief executive of the Financial Conduct Authority, stepped in to order a review into whether Aviva's attempts to can its preferred stock contravened market abuse rules. The insurer’s move was a howler from a PR perspective, but it did serve to bring these securities back into focus, albeit briefly.

These types of shares are essentially hybrids in that they receive a fixed or variable return, but this is only payable assuming the issuing company has registered a profit. If said company fails to pay a dividend, it is lost forever for holders of the non-cumulative class, whereas cumulative preference shareholders may be paid later when circumstances allow. The kicker is that companies cannot pay a dividend on ordinary shares until they have paid out on preferred stock. The normal tax-free dividend allowance also applies.

There are two other categories worth noting: convertible preference shares, which convert into ordinary stock; and redeemable preference shares, where the initial investment can be repaid. And in the event a company is forced into administration, preference shares will rank behind secured and unsecured creditors, but usually ahead of other securities in the recovery of capital.

There are certain disadvantages. These securities don’t come with voting rights and there is an opportunity cost because, like a bond, they don’t provide any additional upside when a company’s earnings are strengthening, whereas an ordinary shareholder might garner increased income under those circumstances. Then again, this is usually reflected in the high coupon rates.

Down the years, preferred stock has been issued mainly by financial institutions. The fact that they’re technically classified as equity rather than debt allows companies to keep gearing within a target rate, while avoiding dilution of the ordinary shares in issue. Oddly enough, a preference share which is redeemable at the owner’s request may be accounted for as debt even though legally it is a share of the issuer.

Unfortunately, as from 2026, preference shares will not be classified as a form of (Tier-1) regulatory capital, which could reduce issuance and shrink the size of the market. They might be going out of fashion, as they’ve proved to be an expensive way for companies to raise capital. But given the promise of a steady and predictable yield, they’re worth investigating as conventional income streams dry up, although cumulative preferred stock may be the preferred option given the deteriorating outlook for corporate payouts.