Thu | Mar 4, 2021

Oran Hall | Choosing between repos and preference shares

Published:Sunday | February 21, 2021 | 12:15 AM

QUESTION: I read with much interest your column on preference and ordinary shares. It was very timely because I am thinking about removing an investment I have in repos at a financial institution and using the funds to purchase the preference...

QUESTION: I read with much interest your column on preference and ordinary shares. It was very timely because I am thinking about removing an investment I have in repos at a financial institution and using the funds to purchase the preference shares being offered by JMMB. In your column you mentioned that preference shares are for low-risk investors. I am a retiree and want an investment that gives me a secure income stream. I would like to find out if you would recommend that I purchase the preference shares, or should I keep the investment in repos? The interest rate I am getting for the repo is 4 per cent and the rate advertised for the preference shares is 7.35 per cent.

– Cameron

FINANCIAL ADVISERS: Repurchase agreements, or repos, and preference shares are suitable securities for investors whose investment objective is income. Both also, to a great extent, satisfy the ‘security of principal’ objective.

Repos are contracts by which the holder of a security, often a Government of Jamaica or Bank of Jamaica financial instrument, sells it with an undertaking to buy it back and pay interest to the buyer at an agreed rate at a specified future date.

The holder of redeemable preference shares receives the principal sum when the issuer redeems, or buys back, the shares. Dividends are paid during the life of the instrument, how frequently being determined by the issuer.

The term of the subject preference shares is seven years, but I do not know the term of the repos you are holding. The term of such instruments is not generally more than one year, but it could be as low as 30 days.

Dividends on the preference shares you refer to are to be paid at a much higher rate than on the repos and are to be paid monthly. How often you receive interest on your repos is a function of the term, or life, of the instrument. I figure it matters to you how often you get a return from your investment for the sake of your cash flow needs.

If you are invested in 30-day repos, you will receive cash with roughly the same frequency as the preference shares are offering. If the term of the repos is longer, dividends on the preference shares would come into your hands more frequently.

The dividends are at a fixed rate for the life of the instrument. I doubt interest rates will increase meaningfully for the foreseeable future, so the rate on new repos to be issued as current ones mature will not likely change significantly. Bear in mind that the rate on each issue of repos could conceivably rise or fall as interest rates change in the economy.

The short-term nature of repos tends to make them more liquid, and they do not lose value, maturing at 100 per cent of the price at which they are issued. The shorter their term, the more readily cash would be available to you should you need to liquidate the principal.

Preference shares also mature at 100 per cent of the issue price, but their price could change during their life if interest rates change generally, rising when interest rates fall and falling when they increase. You would only risk losing capital if it becomes necessary to sell before the redemption date, and you would only be able to sell, through the Jamaica Stock Exchange if it is approved for listing, if there is a buyer.

Being cumulative, preference shares adds more certainty to dividends being paid as any payment missed is required to be paid in the future. There is additional protection: preference dividends are paid ahead of dividends on ordinary shares and the principal ranks ahead of ordinary shares in the event of the dissolution of the company.

The protection given the holders of repos is that the backing security, enough to cover principal and interest, is held by the trustee, quite likely the Jamaica Central Securities Depository, as you are a retail investor. This makes them quite safe.

How safe preference shares are depends on the financial strength and profitability of the issuer, on which the capacity to pay dividends and redeem the shares rests.

Repos are generally more secure than preference shares, but the preferred shares you are considering are being issued by a strong company. Choose the instrument that best matches your cash flow needs by timing and amount, that offers a more certain income, and that makes you more confident your principal is secure.

- Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.