[TOP STORY] CoreShares’ pref share JSE Pref TX is leaving the market

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SIMON BROWN: I’m chatting with Chris Rule, head of product and client solutions at CoreShares. Their preference share ETF – code on the JSE PrefTX – is going to be leaving the market.

Chris, I appreciate the time. If we go back with a bit of history, 15 years or so, the preference share market was robust on our exchange. But [with] changes to Basel III capital, Tier 1, suddenly that space has been dwindling and is continuing to dwindle.

CHRIS RULE: Absolutely. The pref market has always been one dominated by the banks. Around, say, three-quarters of the pref markets and outstanding issuances were bank-led issuances. And in 2012 the Basel III updates meant that for the banks the preference share instruments that were on the market no longer qualified as Tier 1 capital. They started what they call ‘grandfathering’ the capital nature of them. In other words, 10% a year was moved out of, let’s say, Tier 1 capital into Tier 2 over a period of 10 years, up until last year when there was no more Tier 1 capital attached to the preference instruments.

And so what you’ve seen with the banks is they’ve been redeeming all of their prefs – not quite all of them yet, but certainly some of the large issuances out there – Nedbank’s, FirstRand’s – some of the invested prefs. Those are banks’ prefs that have left our market. As a consequence, so has a lot of the liquidity and the investability for big funds like our pref ETF.

Listen/read: Integral Asset Management’s Keith McLachlan explains preference shares and what’s happening in this space

SIMON BROWN: To the point, the preference shares will in time disappear from the market, which means that the ETF is no longer viable as a product. So you’re going through a ballot process to essentially change it into what would be a bond ETF?

CHRIS RULE: That’s correct. To be clear, the prefs will still exist in the market and there may be small issuances, but from a liquidity perspective there just isn’t sufficient diversification and liquidity for us to manage a fund based on that. So yes, we have done quite a lot of work with the regulators. This is quite an unusual balloting process insofar as we received a suspension and a provision of our deed, which basically means because of this potential liquidity problem we’ve got an exception that says we can hold cash in our funds.

So at the moment we are holding cash. As the banks redeem off-market, we don’t reinvest into an asset class that’s getting less and less liquid because we believe that would put our investors at severe liquidity risk.

Effectively the work we’ve done with investors and with some of our anchor clients in this fund is to say what the intent of holding the fund is. I’ve a long history with this pref ETF from its listing in 2012, and the intent has always been to seek out yields.

Unfortunately, one of the by-products of the pref ETF was always tax-efficient yield, which we didn’t manage to solve. But insofar as the pursuit of yield, clients were willing to take on a little more volatility and so they held the pref instruments.

So we have designed a bond fund. We actually have already run it as a unit trust, and that bond fund is effectively a long-duration or a high-yield bond fund, where we buy only South African government bonds, but we buy the long end. In other words, we buy the high-yielding bonds.

So for those clients who are looking to eke out a little more yield, but at the expense of a little more volatility and potentially more duration risk, that’s the idea – a re-mandate to a bond index of that nature.

SIMON BROWN: I take your point on the tax, because of course the prefs paid dividends, whereas interest is taxed differently, taxed as income. Depending on your rate, it could be a whole lot more. And the balancing process you said is different, because, to use a phrase, you guys have kind of been squeezed into a corner around this. This is beyond your control. But the process is going to be – is there a vote? Can people reject it? Surely if they reject it, they should then just exit?

CHRIS RULE: Yes, exactly. They can reject it. Investors have their rights, and their rights are to either vote in favour or against. They can abstain as well, and just not vote.

We would encourage investors to vote, because it’s important for them to understand what’s happening in their product, and at least if they’re voting we know that they’re participating and understand the change afoot.

So if they vote against, which is possible, effectively we go through two ballot rounds.

If we get a quorum of more than 25% and everyone’s voted against, we would essentially close this product around September and pay investors back their money.

So that is the suspension of that provision in the deed [that] I chatted earlier about, which the FSCA granted us. It was gazetted publicly at the end of last year. That gives us a year to either effectively re-mandate the fund or close the fund. So a negative vote would mean the fund closing.

SIMON BROWN: I’m imagining that, that you’ve engaged with folks. And of course the issue with pref shares is well known. It’s likely to happen. And then it’ll just seamlessly convert, maybe [with] a new name and new constituents.

CHRIS RULE: Exactly. Yes. It is important for some investors. The pref market’s been through a bit of a rollercoaster over the last 10 years. We had the introduction of DWT (dividends withholdings tax), if you recall that, and the prefs sold off and there were a whole lot of African Bank scenarios. A lot of the prefs got hit by some sort of credit risk.

SIMON BROWN: Yes. Steinhoff as wel..

CHRIS RULE: … in the market, Steinhoff. There’s been a lot of volatility in that market.

But if you were an investor buying into this instrument two years ago, you’ve got 40%-odd capital gains. So it’s most certainly a consideration for investors to think about the balancing process.

The change of mandate means there’s no tax event, whereas a closure of the fund is effectively us paying capital back, and it’s a deemed sale. So that would be a CGT [capital gains tax] event for clients.

So what is efficient for clients is that they’re not incurring costs of trading out of the ETF instrument and then into something else. We would do that at the fund level and at wholesale brokerage rates. And then effectively, because it’s a re-mandate and not a sale, there’s the continuation of the rollover of your CGT liability, which is far more efficient than selling out and buying something else if you do have that capital gain in your holding.

SIMON BROWN: I hadn’t even thought of that capital gain. We’ll leave it there. If you’re holding the ETF, you’ll get contacted by your broker to vote. Vote, always vote, always be voting.

Chris Rule, head of product and client solutions at CoreShares, I appreciate the time.

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