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22-11-2010, 05:57 AM
Nov 22, 2010
CAI JIN
Preferable to exercise caution
Key lesson from US mortgage crisis: It pays to look beyond dividends for preference shares
By Goh Eng Yeow, Senior Correspondent
TWO years ago, small investors felt hard done by when DBS Bank left them out in the cold in issuing a batch of preference shares, a bond-like investment.
So when it unveiled a similar issuance two weeks ago, this time catering to modest investment budgets, these small investors lost no time in jumping in.
The big attraction is the bank's proven track record which offers comfort to them that their hard-earned cash is going into a stable investment.
Another major draw is the attractive annual dividend payout of 4.7 per cent which beats hands down the meagre 0.125 per cent interest offered on bank savings accounts.
Until recently, preference shares were usually offered only to sophisticated investors such as insurance firms and wealthy individuals, as they are sold in tranches of $250,000 each. This puts them out of the reach of most retail investors.
But when DBS raised $1.7 billion from a preference share issue sold to institutional investors last month, it said that it might make a retail tranche available.
It was true to its word and, to make trading easier for retail investors, the lot size for the preference shares was reduced to just $10,000.
Considering the earlier misgivings that the bank had over the suitability of the product for small investors, it must have been rather surprised at the overwhelming response it received from them.
DBS had initially unveiled a $500 million retail offering. But it had to boost the offer to $800 million, after drawing more than $1.4 billion in subscriptions through ATMs and the bank's Internet banking platform, and another $400 million from institutional investors and DBS staff.
This more than made up for any disappointment which mom-and-pop investors might have felt two years ago when they were excluded from the bountiful feast which DBS had served up to sophisticated investors with an earlier $1.5 billion preference share offering.
Despite the big vote of confidence, however, some discerning investors are asking how the bank can pay out an attractive 4.7 per cent dividend on its preference shares when it is getting a far lower 1.8 per cent net interest margin on its loans.
Answering the question will require an understanding of how a bank manages its finances and some of the parameters used by analysts to measure its performance.
As everyone knows, a bank's business is to collect deposits and lend them at a higher interest rate to anyone needing funds for a whole host of activities from buying a home to operating a business.
But to ensure that depositors get their money back if a loan turns sour, regulators give banks a set of guidelines on the amount of capital that they are required to maintain as a buffer to back up their lending activities. In banking, this is known as the capital adequacy ratio.
To give an example, let's say a bank enjoys a net interest margin of 1 per cent. If it lends out $1 billion in loans, it will make a net profit of $10 million.
Put simply, if it is required to keep a capital adequacy ratio of 10 per cent, this means it will be required to set aside $100 million as capital to indemnify depositors in case some of the loans turn bad.
It can do this by either raising the entire sum from shareholders, or though a mixture of fund-raising from shareholders and selling preference shares.
But how it gets the capital will affect an important parameter tracking its performance - its return on equity.
With a net profit of $10 million, a bank will have a return on equity of 10 per cent if it raises the entire $100 million from shareholders.
But if it sells $50 million worth of preference shares and offers investors a 5 per cent payout, its profit will fall to $7.5 million, while its return on equity will rise to a whopping 15 per cent.
This explains why, even in a low interest rate environment, a bank can offer an attractive payout for preference shares. For some banks, it is also a more enticing option to raise capital, as it can give a boost to its return on equity.
For holders of preference shares, the high dividend payout helps to partly compensate them for missing out on any appreciation which a bank's shareholder will get on his investment, if the bank's share price rises.
But the downside is that as preference shares are regarded as a bank's core capital, he may not get any payment if the bank posts a loss and is unable to make any dividend payout.
For local lenders, the chances of such a mishap are remote. OCBC Bank stated in its preference shares document to retail investors two years ago that it had paid dividend on its shares every year since the end of World War II.
Still, it is important not to take such apparent rock-solid stability for granted, given the lessons of the global financial crisis two years ago.
Not many Singaporeans would have heard of Fannie Mae and Freddie Mac, two giant real estate lenders in the United States which billionaire Warren Buffett recently called the twin pillars of the country's mortgage system.
As both of them were backed by the US government, it was difficult to believe they could fail. But fail they did - in September 2008 - when they were forced into 'conservatorship' after losing billions of dollars on the rotting US mortgage market.
After they went belly up, the unthinkable happened: the billions of dollars in preference shares issued by them turned into worthless paper overnight.
It is a grim reminder of the risks facing holders of preference shares, no matter how remote the chances that these risks might become reality.
So far, the only institutions to issue preference shares in Singapore in the past two years are our local lenders which are well known for their prudent and conservative business practices.
But there is a likelihood that some companies may issue preference shares as an alternative means of raising capital. This being the case, it may be important for investors to look beyond the dividend on offer and study their business carefully, before jumping in.
engyeow@sph.com.sg
CAI JIN
Preferable to exercise caution
Key lesson from US mortgage crisis: It pays to look beyond dividends for preference shares
By Goh Eng Yeow, Senior Correspondent
TWO years ago, small investors felt hard done by when DBS Bank left them out in the cold in issuing a batch of preference shares, a bond-like investment.
So when it unveiled a similar issuance two weeks ago, this time catering to modest investment budgets, these small investors lost no time in jumping in.
The big attraction is the bank's proven track record which offers comfort to them that their hard-earned cash is going into a stable investment.
Another major draw is the attractive annual dividend payout of 4.7 per cent which beats hands down the meagre 0.125 per cent interest offered on bank savings accounts.
Until recently, preference shares were usually offered only to sophisticated investors such as insurance firms and wealthy individuals, as they are sold in tranches of $250,000 each. This puts them out of the reach of most retail investors.
But when DBS raised $1.7 billion from a preference share issue sold to institutional investors last month, it said that it might make a retail tranche available.
It was true to its word and, to make trading easier for retail investors, the lot size for the preference shares was reduced to just $10,000.
Considering the earlier misgivings that the bank had over the suitability of the product for small investors, it must have been rather surprised at the overwhelming response it received from them.
DBS had initially unveiled a $500 million retail offering. But it had to boost the offer to $800 million, after drawing more than $1.4 billion in subscriptions through ATMs and the bank's Internet banking platform, and another $400 million from institutional investors and DBS staff.
This more than made up for any disappointment which mom-and-pop investors might have felt two years ago when they were excluded from the bountiful feast which DBS had served up to sophisticated investors with an earlier $1.5 billion preference share offering.
Despite the big vote of confidence, however, some discerning investors are asking how the bank can pay out an attractive 4.7 per cent dividend on its preference shares when it is getting a far lower 1.8 per cent net interest margin on its loans.
Answering the question will require an understanding of how a bank manages its finances and some of the parameters used by analysts to measure its performance.
As everyone knows, a bank's business is to collect deposits and lend them at a higher interest rate to anyone needing funds for a whole host of activities from buying a home to operating a business.
But to ensure that depositors get their money back if a loan turns sour, regulators give banks a set of guidelines on the amount of capital that they are required to maintain as a buffer to back up their lending activities. In banking, this is known as the capital adequacy ratio.
To give an example, let's say a bank enjoys a net interest margin of 1 per cent. If it lends out $1 billion in loans, it will make a net profit of $10 million.
Put simply, if it is required to keep a capital adequacy ratio of 10 per cent, this means it will be required to set aside $100 million as capital to indemnify depositors in case some of the loans turn bad.
It can do this by either raising the entire sum from shareholders, or though a mixture of fund-raising from shareholders and selling preference shares.
But how it gets the capital will affect an important parameter tracking its performance - its return on equity.
With a net profit of $10 million, a bank will have a return on equity of 10 per cent if it raises the entire $100 million from shareholders.
But if it sells $50 million worth of preference shares and offers investors a 5 per cent payout, its profit will fall to $7.5 million, while its return on equity will rise to a whopping 15 per cent.
This explains why, even in a low interest rate environment, a bank can offer an attractive payout for preference shares. For some banks, it is also a more enticing option to raise capital, as it can give a boost to its return on equity.
For holders of preference shares, the high dividend payout helps to partly compensate them for missing out on any appreciation which a bank's shareholder will get on his investment, if the bank's share price rises.
But the downside is that as preference shares are regarded as a bank's core capital, he may not get any payment if the bank posts a loss and is unable to make any dividend payout.
For local lenders, the chances of such a mishap are remote. OCBC Bank stated in its preference shares document to retail investors two years ago that it had paid dividend on its shares every year since the end of World War II.
Still, it is important not to take such apparent rock-solid stability for granted, given the lessons of the global financial crisis two years ago.
Not many Singaporeans would have heard of Fannie Mae and Freddie Mac, two giant real estate lenders in the United States which billionaire Warren Buffett recently called the twin pillars of the country's mortgage system.
As both of them were backed by the US government, it was difficult to believe they could fail. But fail they did - in September 2008 - when they were forced into 'conservatorship' after losing billions of dollars on the rotting US mortgage market.
After they went belly up, the unthinkable happened: the billions of dollars in preference shares issued by them turned into worthless paper overnight.
It is a grim reminder of the risks facing holders of preference shares, no matter how remote the chances that these risks might become reality.
So far, the only institutions to issue preference shares in Singapore in the past two years are our local lenders which are well known for their prudent and conservative business practices.
But there is a likelihood that some companies may issue preference shares as an alternative means of raising capital. This being the case, it may be important for investors to look beyond the dividend on offer and study their business carefully, before jumping in.
engyeow@sph.com.sg
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