Earn more income

By Ken Howard, RBS Morgans

Are you looking to outperform cash? Are you prepared to take some risk?
Do you have a bias towards income? If so, preference shares and hybrid securities should be considered as part of your portfolio construction.

(Editor's note: To learn about the features, benefits and risks of ASX-listed interest rate securities do the free online ASX interest rate securities course.)

Over the long term, ordinary shares should generate the greatest return, and if you are a "glass half full" investor you may find it hard to buy preference shares or hybrid securities where your upside is capped. But as the past couple of years have reinforced, predicting where a share price will be in a year or two is impossible and in five years doubly so.

Therefore, having some investments in your portfolio producing a reasonable return and with a maturity date is something to consider.

Of course, the reality is the maturity date is a promise, not a guarantee, and there are certainly examples where the date has come and gone and the securities have not been redeemed or converted and even examples where both ordinary shares and preference shares have become worthless. So in short, you have to be happy with the issuer of the security and the terms of the issue.

The Australian sharemarket is trading around 14-month highs and for the first time in a number of years it is because the defensive income-producing companies are in favour compared to mining and resource companies. Companies such as Transurban, Sydney Airports, Spark Infrastructure and Telstra are trading around multi-year highs, which is another reason to review the place of preference shares in a portfolio.

The recent CBA-PERLS VI and current Suncorp preference share issues have attracted a degree of negative press, with phrases like "booby-traps", so I will add some comment to the debate.

Bank preference shares do form part of a bank's regulatory capital, which means if everything is going wrong for the bank, everything will be going wrong for preference shareholders and ordinary shareholders alike. Preference shares are not term deposits or cash in the bank. They are part of a bank's ownership structure.

However, if bank performance wanes, then ordinary shareholders are likely to carry the cost of poor performance while preference shareholders are likely to be kept whole.

(Editor's note: Do not read the following idea as security recommendations. Do further research of your own or talk to your financial adviser before acting on themes in this article).

CBA as an example

The CBA preference shares are a promise from CBA to pay 3.8 per cent above the 90-day bank bill swap rate (the interest rate targeted by the Reserve Bank), with a "first call" date of December 15, 2018. This is the first date that CBA could, under "normal conditions", convert the preference shares (normal conditions is another way of saying with the regulator APRA's consent).

In simple terms, for the CBA to keep its promise, APRA needs to be comfortable that CBA is sufficiently profitable and stable to protect depositors.

In practical terms, I could not imagine CBA's balance sheet being under threat. Then again, until it happened I probably could not imagine the failure of Lehman Brothers or the global financial crisis.

To keep it in perspective, for the CBA balance sheet to be under threat you would have to be talking about an economic environment where unemployment was well above 10 per cent and property prices had fallen 30 per cent, and bad and doubtful debts were multiples of current levels. So not impossible, but fortunately/hopefully very unlikely.

Under a scenario where CBA remains profitable yet experiencing little or no earnings growth over the next six years, preference shareholders may well find they capture the lion's share of the return experienced by ordinary shareholders.

Preference shares may actually outperform the ordinary shares, particularly when you consider the volatility ordinary shareholders have experienced in the past couple of years. For CBA, the trading range low to high has been 30 per cent in the past 12 months and the current share price is still below levels in 2010 and almost 10 per cent below the record high reached in 2007.

I do not see it as a question of "do I own ordinary shares or do I own preference shares". I see a place for both in most portfolios and feel if clients can earn 3.8 per cent above the targeted RBA rate then they are actually doing OK. I would, of course, like the sharemarket to do better; the S&P/ASX 200 index is still down 35 per cent from 2007.

Accepting the risk

I should highlight the perpetual securities (i.e. no maturity date) in the hybrid space. The lack of a maturity date is a distinct negative for conservative investors, but for those prepared to own ordinary shares it is a risk they are obviously already prepared to accept.

Take, for example, the Macquarie Income securities (MBLHB). They were issued before the GFC with a face value of $100 but currently trade around $65. The securities pay an annual rate of 1.7 per cent above the 90-day bank bill swap rate (currently around 3.3 per cent) on the face value of $100. This would equate to $5 per year. On a $65 purchase price, this would equal a running yield of 7.7 per cent.

If you assume that at some point in the next 10 years (and it could take 20 years) credit markets improve to pre-GFC levels and Macquarie Bank is able to borrow money at 1.7 per cent over the 90-day bank bill swap rate, there is every chance the securities will be back trading at $100.

This would add 4.4 per cent per annum to your annual return (if it takes 20 years it equals 2.17 per cent per annum). So if you assume the bank bill swap rate does not change and the running yield of 7.7 per cent is constant for the next 10 years, and you add 4.4 per cent growth, it will equal 12.1 per cent per annum over 10 years.

Another way of looking at it is to ignore any potential for the MBLHB to return to $100 and just consider the possibility that the RBA will actually lifts interest rates in the next 10 years from 3.25 per cent to, say, 6 per cent. The distribution would be $7.7 per year or a yield of 11.8 per cent (on a purchase price of $65).

I would like to believe the most likely scenario is a combination of higher interest rates from the RBA and "normalised" global credit markets. Therefore, if you are happy to own Macquarie Bank ordinary shares you should consider owning the Macquarie Bank Income securities, because (a) the potential return looks reasonable (certainly relative to the RBA rate) and (b) you may actually outperform the ordinary shares.

About the author

Ken Howard is a stockbroker and financial planner. He has worked with RBS Morgans since 2001 and in the financial services industry since 1996. He has adopted a fundamental approach to investing, looking for value and quality in long-term investments.

His strategy is biased towards investments with a long history of paying dividends and distributions. For more about higher-yielding shares in 2012, phone him on 07-3334 4856 or email.

From ASX

The ASX interest rate securities course is especially popular with long-term investors who want more predictable income through ASX-listed bonds or hybrid securities that have fixed or floating interest rates. More companies are expected to launch interest-rate securities, so it is a good time to learn about this market.