Considering DBS Preference shares

November 11, 2010 Thursday, 10:27 AM

Goh Eng Yeow examines the attractions of preference shares

JUST over two years ago, I wrote a commentary to highlight the unhappiness of small investors being left out of DBS Bank’s $1.5 billion preference shares offering.

Surely, there must be some way to enable them to enjoy the much higher payout offered by the preference shares, rather than the pittance they are getting from their accounts with POSB, which is now part of DBS.

That is about to change. The bank yesterday announced that it is offering up to $800 million worth of new preference shares to retail investors. It has also taken out a full-page advertisement in The Straits Times today about the offering.

It is a big change in mindset for the bank.

As my colleague Gabriel Chen highlighted in his article this morning, DBS did not sell preference shares to the public in 2008 because of misgivings that the product would not be suitable for retail investors.

Indeed, investors who had bought the preference shares offered by OCBC Bank and United Overseas Bank – soon after the DBS offering – suffered paper losses on their investments as they crashed below issue price when Lehman Brothers failed a few months later.

Of course, those who have held on to their investments are now laughing all the way back to the bank, as the preference shares have climbed back to well above par value.

Compared to the DBS preference shares offering which offered a 5.75 per cent dividend payout, the current offering is not as attractive, since its payout is only 4.7 per cent.

But real interest rates have sunk into negative territory, as the US central bank’s printing presses go into over-drive. Getting the yield from the preference shares will at least help to preserve the value of the savings.

I got a few calls this morning asking me about the risks involved.

Let me stress that unlike a bond, there are risks associated with a preference share.

The issuer is not obliged to pay the dividend on the preference shares, if he suffers a loss and does not have money to declare any dividend payout to his shareholders.

Considering that our lenders are financially prudent and are consistently profitable, this is a scenario which is unlikely to occur here.

But the recent global financial crisis has shown that nothing is impossible, even for institutions which are believed to be too big to fail.

The best examples are the US-government backed mortgage giants Freddie Mac and Fannie Mae, whose preference shareholders were completely wiped out when the two companies were put under "conservatorship" – whose nearest equivalent here would be judicial management.

What happened was that both firms were unable to pay the dividend on their preference shares because of their heavy losses, forcing the many funds holding them to write their value down to zero. The logic is ruthlessly simple: If it doesn't offer a payout, it is effectively a worthless piece of paper. 

It must have come as a big shock to these investors, that the two firms holding a big chunk of the US mortgages, could collapse in such a spectacular fashion.

But the local lenders are strongly supported by their shareholders.

Last year, when the financial storm was raging at its peak, DBS boldly came out with a rights issue to strengthen its capital base and it  was oversubscribed. OCBC revived its scrip dividend scheme and persuaded the majority of its shareholders to opt for shares, rather than cash, for their dividend payout.  

So, those planning to invest in preference shares should know what they are in for.

It is not simply about getting that attractive coupon in the preference shares offered by the issuer. You also have to carefully study the business it is in, and how well it is being supported by its shareholders. Then again, isn't that true of all investments?

Happy investing.