A glance at the Financial Times of 100 years ago would revealed reams of copy on preference shares, yet the all-but-forgotten asset class is about to enter a renaissance says Nick Train, manager of the Finsbury Growth and Income investment trust.
Having achieved a new mandate from shareholders through yesterday’s EGM for both a change of name and of strategy to include “Income”, Train’s fund is now targeting a 4.25% yield by gearing up and putting the borrowed money in preference shares.
These provide a steady stream of income to meet the new mandate, and with “prefs” (preference shares) of companies such as HBOS delivering a net yield of 7%, it is an area equity investors exclude at their peril, Train says.
”Private investors get it, but institutions often don’t, although not necessarily because they don’t understand it. For example, institutions may not be able to hold prefs as they are not offered through investments included in their benchmarks. Bond funds cannot use prefs because strictly speaking they are not bonds.”
It’s a bit of a backwater these days,” Train admits, “But people who need income should at least take a look at preference shares.”
The oft bypassing of prefs is a shame, Train adds, because prefs can offer 200 basis points or more above the corporate bond issued by the same company. The difference can be explained away by issues of “credit risk”, but if the underlying company is solid there should be no reason not to consider prefs instead, Train says.
Since the mid-1990s there have been virtually no new issues of preference shares. However, Train estimates a market of some £2bn worth of prefs for the FG&I fund to tap, which for a fund with a market capitalisation value of about £70m is plenty to be getting on with. Rumours are that Royal Bank of Scotland may issue prefs to help pay for the acquisition of Charter One, the US bank deal announced last week.
To maximise the advantages of prefs, the FG&I fund will increase its gearing from about 10% to 20%, and use that extra gearing to acquire such shares. The fund will go from about 9% of gross assets in prefs to about 20%.
By shifting to prefs, the fund frees up the whole of the original equity portfolio, that is, excluding the borrowed money, to focus on dividend growth as opposed to existing yield, Train says.
This essentially means the fund can use more of shareholders original capital invested to buy future income – by holding a greater proportion of ordinary shares in the portfolio in companies with faster-growing dividends – and investing less original shareholder capital on ensuring the fund meets current income needs. These current income needs are instead covered by the prefs.
Many of the stocks in Train’s existing portfolio have grown their dividends more than 100% in the past 10 years, and will remain in the fund even after the implementation of the new mandate voted on at yesterday’s EGM.
Unlike similar funds, Train has excluded holdings in tobacco companies and BP in favour of beverage makers and distillers such as AG Barr – which makes Irn Bru – and whisky maker Glenmorangie: they have increased dividends by 273% and 119% respectively in the past decade.
Top dividend wealth creator in the portfolio is Sage, the accounting software maker, which has increased its dividend by more than 750% in the past 10 years, and could still cover a dividend payout three times the current level without falling below the FTSE All Share average cover multiple, Train says.IFAonline
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