HYP1 vs. Preference Shares

General discussions about equity high-yield income strategies
moorfield
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HYP1 vs. Preference Shares

Postby moorfield » November 15th, 2016, 12:44 pm

Hello All

On the other board's HYP1 review I posted some evidence to suggest that, ignoring capital values, preference shares can outperform pyad's original HYP strategy over a long period of time:

viewtopic.php?f=15&t=432&start=40#p4565
Doris could have purchased AV.A (Aviva 8.75%) preference shares at 131.50p in February 2001 (on the same day as I did). Her £75000 would now be worth only £85059 but the shares would have returned an annual dividend of £4990, a total of £79840 against HYP1's £68758 over the same 16 year period.


In my mind this raises an interesting actuarial question:

How long does it take for a high and rising dividend income to overtake a higher and fixed dividend income?

It's impossible to answer precisely of course, but I think one can investigate a little further with some reasonable starting assumptions.

My own attempt below shows: the cumulative income on £1 invested in a preference share yielding 6.0% (currently the lowest yield of my own preference shares), versus the cumulative income on £1 invested in an ordinary share yielding 4.4% (currently the yield of my own portfolio excluding preference shares and VCTs) and growing the initial dividend at 2.5% per annum (the Bank of England's original inflation target), both without any dividend cuts. All income is spent and not reinvested.

Code: Select all

YEAR    PREF     ORD
 1      0.060   0.044
 2      0.120   0.089
 3      0.180   0.135
 4      0.240   0.183
 5      0.300   0.231
 6      0.360   0.281
 7      0.420   0.332
 8      0.480   0.384
 9      0.540   0.438
10      0.600   0.493
11      0.660   0.549
12      0.720   0.607
13      0.780   0.666
14      0.840   0.727
15      0.900   0.789
16      0.960   0.853
17      1.020   0.918
18      1.080   0.985
19      1.140   1.054
20      1.200   1.124


After 20 years the preference share has paid a total of £1.20 on the initial £1 investment. The ordinary share has paid a total of £1.12 and still not caught up.

In comparison, men and women retiring at 65 can expect to live a further 14 (to 79) and 17 (to 82) years respectively (according to my quick search of Office for National Statistics figures).

M

thebarns
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Re: HYP1 vs. Preference Shares

Postby thebarns » November 15th, 2016, 1:15 pm

Moorfield,

You have a point on the increased income available from the prefs route and I note you state to ignore capital values.

However, inherently prefs are pretty narrow in terms of sectors and numbers of prefs.

There would be a significantly increased risk, in the event of some global banking calamity, that prefs could cease payouts altogether, compared to a spread of high yielding shares, which would be extremely unlikely to cease all at once.

So one trades off the higher income against a higher risk of these payouts being maintained.

moorfield
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Re: HYP1 vs. Preference Shares

Postby moorfield » November 15th, 2016, 2:12 pm

However, inherently prefs are pretty narrow in terms of sectors and numbers of prefs.


Quite right in practice there is a small pool to choose from mostly within the Financials industry. I hold RE.B (Farming & Fishing), SAN, STAC (Banks) and AV.A (Insurance) however these four currently contribute 25.1% of my overall portfolio income which is currently being reinvested for the foreseeable future rather than drawn down.

There would be a significantly increased risk, in the event of some global banking calamity, that prefs could cease payouts altogether, compared to a spread of high yielding shares, which would be extremely unlikely to cease all at once.


Preference shareholders do take precedence over ordinary shareholders in those sectors so these risks are mitigated partially - they must be paid their dividends first (and in full if cumulative), or their capital first in any winding up. Aviva AV.A is the example I provided previously - it's ordinary dividend has been extremely unreliable in the last decade whereas it's preference dividend has been a stalwart for me.

M

Lootman
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Re: HYP1 vs. Preference Shares

Postby Lootman » November 15th, 2016, 3:06 pm

moorfield wrote:In my mind this raises an interesting actuarial question:
How long does it take for a high and rising dividend income to overtake a higher and fixed dividend income?


I think that is a special case of the more general dilemma about whether it is better to have a high initial yield with lower dividend growth or a lower initial yield and a faster growing dividend, Obviously that depends on your investment objectives and your age and situation at the time the decision is being made.

But either way there is more to the issue than just when the total amount of income "crosses over", and for two reasons:

1) Other things being equal, a pound today is worth more than a pound in a few years time, absent deflation anyway

2) The chances are that a share with a faster rising dividend will also have a faster growing share price, otherwise the dividend yield will become very high and it's P/E will become very low. And while you might think that "capital doesn't matter" there are a variety of situations where it will matter even if you maintain an attitude of total indifference to it.

in some ways it is like the dilemma over whether to start taking a pension as soon as you can or defer it to get a higher monthly payout. Again you have to look at the time value of money and the crossover point relative to your best guess at life expectancy. As I said, it's a personal matter and so far I am taking the view that the jam tomorrow approach will serve me better in the long-term, whilst if there is no long-term for me then it won't matter either way.

Alaric
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Re: HYP1 vs. Preference Shares

Postby Alaric » November 15th, 2016, 3:25 pm

Lootman wrote: And while you might think that "capital doesn't matter" there are a variety of situations where it will matter even if you maintain an attitude of total indifference to it.


A running income of 4.4% increasing at 2.5% is worth more than a flat income of 6%. The point being that the capital value is increasing, probably, in the increasing case. The ideology of HYP was not to sell, but it shouldn't override rational judgements as to which return is higher.

Lootman
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Re: HYP1 vs. Preference Shares

Postby Lootman » November 15th, 2016, 4:19 pm

Alaric wrote: The ideology of HYP was not to sell, but it shouldn't override rational judgements as to which return is higher.

Depends which form of HYP you mean. There are certainly forms or styles of HYP where the portfolio is re-balanced, and TJH has reported detailed records showing how that has worked very well. Others have a policy of selling off any share that cuts or cancels its dividend.

And of course there are periodic corporate actions that impose a sale. In those case, a higher capital sum will enable the purchase of more new income and so capital absolutely does matter in those cases.

Finally, none of us can predict the future and our income needs at some point may exceed the value of ones dividends, in which case one will need to switch over to a drawdown mode where, again, capital very much matters.

taken2often
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Re: HYP1 vs. Preference Shares

Postby taken2often » November 15th, 2016, 10:18 pm

I also bought many Preference shares over the past 15 years. I used much of the income to buy dividend growth income shares
It is nearly impossible to work out the compounding effect. All I know is I have an annual increasing income of much more than I need to live on.
I reality I have built my own indexed annuity.

Bob

taken2often
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Re: HYP1 vs. Preference Shares

Postby taken2often » November 15th, 2016, 10:18 pm

I also bought many Preference shares over the past 15 years. I used much of the income to buy dividend growth income shares
It is nearly impossible to work out the compounding effect. All I know is I have an annual increasing income of much more than I need to live on.
I reality I have built my own indexed annuity.

Bob

taken2often
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Re: HYP1 vs. Preference Shares

Postby taken2often » November 15th, 2016, 10:18 pm

I also bought many Preference shares over the past 15 years. I used much of the income to buy dividend growth income shares
It is nearly impossible to work out the compounding effect. All I know is I have an annual increasing income of much more than I need to live on.
I reality I have built my own indexed annuity.

Bob

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Re: HYP1 vs. Preference Shares

Postby Wizard » November 16th, 2016, 12:15 am

moorfield wrote:I hold RE.B (Farming & Fishing)


Fishing, wow, I own these but never knew that, I know they dabbled in coal for a bit but had never picked up on fishing. Worth pointing out the current dividend on these is a touch over 9% as they are primarily in palm oil (I know some who won't buy for moral reasons) and this has tracked oil lower and raised some concerns re the business.

Don't forget RUSP which I also hold which operates warehouses in Russia. These yield over 8.5% but who knows what will happen under a Trump presideny and potentially changing attitudes to Russia.

Terry.
Last edited by Wizard on November 16th, 2016, 12:20 am, edited 1 time in total.

Wizard
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Re: HYP1 vs. Preference Shares

Postby Wizard » November 16th, 2016, 12:19 am

thebarns wrote:There would be a significantly increased risk, in the event of some global banking calamity, that prefs could cease payouts altogether, compared to a spread of high yielding shares, which would be extremely unlikely to cease all at once.


Many of the financial sector prefs are 'must pay' and the dividend cannot be easily turned off. For example NWBD which I don't hold paid right through RBS' troubles. Others can be switched off, but for example in the case of LLPC and LLPD which I also hold IIRC must have been paying for 12 months before the ords. can pay a dividend.

But the broader point that they are concentrated in financials is correct. Some of them are also pretty illiquid and the spreads are much wider.

Terry.

tieresias
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Re: HYP1 vs. Preference Shares

Postby tieresias » November 19th, 2016, 1:21 pm

Alaric wrote:A running income of 4.4% increasing at 2.5% is worth more than a flat income of 6%.


On my calculation, the annual income from the first scenario would only reach that of the second scenario after 16 years and the cumulative income would not be equal until year 25.

In the context of retirement/financial independence, one needs to consider how long one might be around for and whether one's need for income will increase or decrease over that period.

Alaric
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Re: HYP1 vs. Preference Shares

Postby Alaric » November 19th, 2016, 3:13 pm

tieresias wrote:In the context of retirement/financial independence, one needs to consider how long one might be around for and whether one's need for income will increase or decrease over that period.


In the context of valuing investments correctly, the residual estate needs to be taken into account. That's why annuities are or can seem poor value in comparison to an invested portfolio as there isn't any residual value.

88V8
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Re: HYP1 vs. Preference Shares

Postby 88V8 » November 19th, 2016, 5:22 pm

LTBH means long-term. Not for ever.

I would never advocate buying Prefs and holding them twenty years before retirement.

But then, I would not advocate taking any HYP into retirement without giving it a good going over. Would you want to take HYP1 into retirement?

Thing is, over the years, fixed interest is eroded by inflation. I'm retired, I probably don't have to worry so much about 'over the years'. But even so, if inflation really gets going again all bets are off. Remember 15%+ ? Bet some of us find that hard to imagine. Not me. So I would never buy Prefs if I were twenty years away from getting the mantle clock.

Now, in my HYP, I hold a lot of Prefs. REB, LLPC, LLPD, LLPC, ELLA, BBYB (which is still paying when Balfour's ords are not, I won’t go on and on about that as it will upset holders of the ords which unfortunately includes my wife, well it seemed a good idea at the time), STAC, SAN, SANB, NWBD, AVA, AVB, GACA, GACB, and others, pretty much the whole suite.

As part of an HYP they are invaluable, imho.

I was lucky. Via the Banking Board I learned about Prefs just in time to catch the tail-end of the high yields, 8% plus, so my timing was quite good and once the Fed starts raising rates instead of just talking about it, I expect and hope to see yields rising again and will once more be a buyer. But then, I’m retired did I say that?

Prefs are indeed a sector concentration. Mostly Financials. I am about a third into Financials This is not very advisable, but we have an income surplus so I accept the risk.

The arithmetic is simple. We can dicker about whether we start our equities at 4.3% - the yield on Luni’s last Elastic Knickers version of his SuperHYP - and inflate by 5% or 2.5%, and whether we start our Prefs at 7% which will soon be achievable. We can debate whether or rather when and to what extent our equities are going to cut or pass. Our Prefs will not cut, and are very unlikely to pass.

The fact is, it takes many many years for a rising lowish start to overtake a static high start. Twenty-five years, tierasias calculates. At my age it's a no-brainer. In 25 years, I will likely be dead. Light a candle for me.

V8

tjh290633
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Re: HYP1 vs. Preference Shares

Postby tjh290633 » November 19th, 2016, 5:54 pm

88V8 wrote:I would never advocate buying Prefs and holding them twenty years before retirement.

But then, I would not advocate taking any HYP into retirement without giving it a good going over. Would you want to take HYP1 into retirement?


Don't forget that HYP1 was proposed by PYAD as a "Buy it all in one go" as opposed to taking out an annuity.

In retrospect the method of dealing with take-over bids and demergers was flawed.

I don't see the logic of buying Prefs unless you need more income. Surely not the case before retirement?

TJH

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Re: HYP1 vs. Preference Shares

Postby Alaric » November 19th, 2016, 7:26 pm

tjh290633 wrote:I don't see the logic of buying Prefs unless you need more income. Surely not the case before retirement?

As compared to shares, the default risk is different and arguably lower. That's been seen with some of the financial sector, where the ordinary shares had dividends cut or suspended whilst the preference shares continued to be paid.

It's long seemed to me that a simple enough method of using a high yielding portfolio as part of retirement planning is that for as long you continue to have non savings earnings, you reinvest the dividends and interest in "more of the same". When eventually the income from these is enough to live on, that's when you cease work and cease reinvesting. Whilst you remain vulnerable to shocks, you will know from some years earlier how much is the minimum income you will have available when you retire.

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Re: HYP1 vs. Preference Shares

Postby Lootman » November 19th, 2016, 7:44 pm

Alaric wrote:As compared to shares, the default risk is different and arguably lower. That's been seen with some of the financial sector, where the ordinary shares had dividends cut or suspended whilst the preference shares continued to be paid.

The 2007-2009 financial crisis didn't reward all preference share holders. It really depended on what happened to the underlying issuer and it was something of a lottery whether the preference shares were wiped out or not.

If an institution failed totally then the preference share holders were wiped out, whilst even the bond holders took a hit and lost much of their principal. If the institution was instead taken over by another bank, then the preference shares became obligations of the acquiring bank, and generally did OK. Indeed, they may have done very well as they were previously priced at a discount to par and, if the acquirer was in good standing, those shares would revert to close to par.

Then there were the institutions that were taken over by the government. In that case, the bonds continued to pay coupons but the preference shares may have had their dividends suspended. If it was a cumulative preferred stock then they may later have been resumed, certainly before ordnary share dividends were resumed.

Although preference shares look and behave like bonds, they are typically structured as equity capital. You might do better than the ordinary shares, but you don't have the contractual and collateral underpinning that the true bonds have.

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Re: HYP1 vs. Preference Shares

Postby 88V8 » November 19th, 2016, 9:04 pm

tjh290633 wrote:I don't see the logic of buying Prefs unless you need more income. Surely not the case before retirement?


Ha! You think one needs less income in retirement?
Perhaps, unless one has expensive hobbies and now the time to indulge them :}

Anyway, if I can safely generate more income, why not........ Safe until the next banking crash at any rate.

V8

tjh290633
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Re: HYP1 vs. Preference Shares

Postby tjh290633 » November 19th, 2016, 10:07 pm

88V8 wrote:
tjh290633 wrote:I don't see the logic of buying Prefs unless you need more income. Surely not the case before retirement?


Ha! You think one needs less income in retirement?

V8


No, I was questioning the rationality of buying preference shares when one is not taking the income. As far as I can see it is only logical to buy them when your equity portfolio is providing insufficient dividend income for your needs.

The object of an HYP is to obtain a high and growing income. Preference shares are fixed interest and so defeat that object.

TJH

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Re: HYP1 vs. Preference Shares

Postby Breelander » November 19th, 2016, 11:10 pm

tjh290633 wrote:The object of an HYP is to obtain a high and growing income. Preference shares are fixed interest and so defeat that object.
TJH


Not necessarily, it's possible to generate a growing income from a fixed interest preference share. The income does need to be significantly higher than that available from equities to allow you to do this though - as it was four years ago when...
Gengulphus (in 2012) wrote:...it really does need to be able to grow the income like the other shares in the portfolio. The only way to do that with preference shares is to reinvest at least part of the dividend income they produce. (Not necessarily in the same share, by the way...
https://web.archive.org/web/20161111233 ... 58107.aspx

Four years ago it was still possible to find preference shares with yields high enough to make that practical. These days the gap between preference and dividend income has narrowed. Synthesising a growing income in this way today would be at the expense of a relatively unattractive 'yield'.


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