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How Risky Are Perpetual Preference Shares?

Contributor:
Mary Holm
Mary Holm

Question:

ASB, Origin Energy and Rabobank perpetual preference shares with annual interest resets seem to be a risky investment.   I feel this was unclear in the original prospectuses.

I do not have the ASB prospectus here, but all Origin Energy has to say, as a specific risk is: "Investors should be aware there are risks associated with an investment in preference shares generally. Some of these risks arise from the nature of preference shares." Vanilla!

This is a meaningless statement and does not even refer to the actual product being offered; that is, perpetual preference shares with annual interest rate resets.

I read the prospectuses and struggled, unsuccessfully, to understand how the shares would react to interest rate changes. However, I did invest in all three issues because they were being offered by highly reputable companies. How naive can one be?

If the true risk of capital loss had been described in those prospectuses, nobody would have touched them with a barge pole.

In my opinion, the Securities Commission and the New Zealand stock exchange should have ensured a fairer and clearer warning of risk was included in these prospectuses.

Both the government and the stock exchange exhort us to invest in productive activities, rather than property. If they are serious, how about levelling the playing field by ensuring we have true, clear and full information on which to base investment decisions?

Answer:

Mary Holm: As you've learnt, a strong company can be a lousy investment.

It's certainly good to know you are in a company that is not likely to go belly up. Origin Energy says the security of its preference shares "has not diminished, and the capacity to pay dividends remains as strong, if not stronger than that at the time the prospectus was issued in August 2007. The reduced price is therefore a result of market factors only" - something that probably applies to all three companies.

But beyond being confident that a company will stick around, what matters is the return you get - which is affected by the price you pay and/or the interest, dividends or rent you receive.

With these perpetual preference shares, the numbers no longer stack up well, and their value has fallen. Did the three companies adequately warn investors that this might happen? I asked them to email me excerpts from their documents that outline that risk.

The following are key quotes from their investment statements or prospectuses.

ASB: "The market price of perpetual preference shares may also decline, and holders may receive less than the issue price they paid for their perpetual preference shares." And, "A holder of perpetual preference shares may, on sale or other termination of that holder's investments, receive less than the issue price."

Origin: "Holders may receive less than the issue price they paid for their preference shares if they choose to sell them." And, "The only way a holder can realise their investment is to sell the preference shares on the NZDX. The price a holder obtains will depend on the market for the preference shares at the time of sale."

Rabobank: "If a holder transfers their capital securities before they are redeemed ... the price at which they are able to sell their capital securities may be less than the price paid for them. This is because changes in the market interest rates and other factors can affect the market value of the capital securities. For example, if market rates go up, the market value of the capital securities may go down, and vice versa."

So they all said it. And while the quotes were often on page 20-something or even page 50-something, the companies pointed out that contents lists should have guided would-be investors to the relevant sections.

Is this good enough? Recent correspondence to this column suggests that lots of people didn't appreciate that their preference share values could fall as much as they have. They might not have bothered to read the prospectuses. But even if they did - as you did - the wording doesn't exactly yell out, "Beware - you could lose lots!"

In defence of the companies, they probably didn't foresee such radical market changes. As a Rabobank spokesman puts it, "As events unfolded in 2008/09, investments with a rate that resets annually became less popular following the RBNZ's decision to cut official cash rates.

"In addition, the market re-evaluation of bank credit saw a fall in the traded prices of all longer term bank securities, whether they were perpetual or not."

The spokesman goes on to say, "It should also be noted that this is only the value of the securities if sold today. Rabobank has an option to buy the securities back in 2017. If Rabobank were to exercise that option, investors would receive 100 per cent for their investment at that time."

ASB and Origin Energy could similarly buy back their preference shares. But will they? There is certainly no guarantee.

In the end I think it's fair to say the three companies should have more clearly warned investors about price falls. Relying on investors to find - and then to understand - a couple of sentences of legalese deep in a document doesn't work.

And this hurts issuers too, because once-bitten investors are hardly likely to line up for the next round.

As you point out, the government, stock exchange and others trying to steer New Zealanders away from property investment would also benefit from investors' being better informed.

The great news is that change is on the way. There are moves afoot to force companies to attach brief summaries to the front of their investment documents that would explain, simply and clearly, important issues like risk. Watch for more info shortly. Such a change can't come soon enough.

One tricky aspect of all this is education of would-be investors. You "struggled, unsuccessfully, to understand how the shares would react to interest rate changes", despite Rabobank's brief explanation.

Basically, any bonds - and preference shares are the same in this respect - will lose value if newer bonds offer higher interest rates. People won't want to buy the older lower-interest bonds unless they can get a bargain price.

Should a company that issues bonds or preference shares be obliged to explain that? Probably not.

But it would be great if they did. A company that treats investors well should be rewarded by greater investor interest in their securities.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.      

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