Insure your portfolio with General Accident prefs

The question then turns to which prefs can be accessed by investors offer decent income and are backed by the financial stability of a well-established parent company. In this context, those with long memories will appreciate the virtues of General Accident’s 8.875 per cent (GACA) cumulative irredeemable preference shares, issued in 1992 by the then independent car insurer, now a subsidiary of Aviva (AV.).

Preference shares are a strange anomaly in the UK market, and are far more prevalent in Europe and the US, where they are known as preferred stock. They are equity instruments that behave like a bond but without a security, listed like a share but without any equity value or voting rights, yet still drawing on the privileges of ownership through a stream of guaranteed income. Nor is there any doubt that prefs and Pibs (the permanent interest-bearing share variant) have remained hugely popular in recent years, to the point where (until a year ago) the benefits of ownership had diminished along with dwindling yields.

Among retail investors, two episodes involving the hybrid asset classes stick in the memory. First is the 46 per cent yield that investors could have earned on NatWest’s 9 per cent (NWBD) prefs at the height of the 2008 financial crisis – if, that is, you had worked out that the shares contained a “must pay” clause obliging the bank to pay out come rain, shine or nationalisation. Throughout a period in which dividend-starved RBS investors sat on huge losses, those canny pref owners who read the small print were guaranteed vast yields.

The second episode came a decade later, when Aviva (AV.) disastrously attempted to redeem a slate of its prefs, including General Accident’s 1992 and 1993 issues, on the grounds that interest rates were far too low compared with the security’s 8 per cent coupons. If nothing else, this illustrates the pref market’s ability to go off on a tangent.

This time, what has really caught the eye is the apparent end of the yield compression that had made prefs a largely inefficient source of income for most of the 2010s. The lowering of prices started in January 2022 after the first announcements of interest rate rises by the Bank of England, along with speculation that this trend would continue. Many long-term owners of prefs liquidated their positions, often cashing in decent capital gains, and moved the money into cash to take advantage of better rates. A similar trend has played out in the bond market, which is the closest comparator class to preference shares.

Some investors will be wary of owning prefs after Aviva’s cack-handed attempt to cancel shares, redeem at par and save itself millions in dividend payments – an action that provoked enough shareholder and regulatory fury to force a volte-face.

The question hinges, inscrutably, on the meaning of “irredeemable”, although Aviva initially argued it had the right to cancel the shares if there was a general vote of its shareholders in favour. In the end, a truce broke out, followed by an apology from the insurer, and something like a line under the matter. However, in the context of rising interest rates the coupons for prefs are becoming less onerous for the issuers. Put differently, when rates rise, prefs fulfil their original intended role of diversifying the capital base of the company.

It is important to remember that a pref investor’s only real concern is the ability of the issuing company to continue paying the coupons on the shares. As such, General Accident holders need to consider the financial health of the parent company, rather than its growth outlook, in a similar way to how bondholders rate the creditworthiness of companies. In the case of Aviva, which is liable for the GACA prefs, its credit rating is high grade. The rating is reinforced by a series of asset sales that have shed Aviva of its peripheral and underperforming businesses and left the balance sheet stuffed with cash and liquidity.

The broader threat to the sector is what happens after 2026 when prefs and Pibs will no longer count towards the regulatory capital requirements for companies under new European rules. There are only really two options in this scenario: either they will be left as they are, or the issuers will seek to cut a deal on redeeming the shares and remove them from the balance sheet. There is also the possibility that UK rules could diverge from Europe on this question, but no concrete proposals emerged from the Chancellor’s recent statement on financial services reform.

Ultimately, it is the price action that counts. If inflation has peaked, as some recent data indicates, then any reversal in interests or inflation fall will cause prefs prices to rise. This means the shares, priced at £1.20 and offering a running yield of 7.4 per cent, puts investors in the sweet spot for potential capital appreciation, as well as decent, if not quite inflation-beating income, if yield progression sets in again. It is a rare moon when the prefs market offers decent buy-in opportunities – at most once a decade – and arguably that time is now.