Preferred shares were born in the American railroad binge of the early nineteenth century. Railway bosses needed additional capital but existing shareholders were reluctant to cough up because of poor returns from earlier investments. In 1836 Maryland legislators introduced a bill offering public funds in return for guaranteed dividends. A new class of stock was created.
The idea lives on. According to Chinese brokerage Guangfa Securities, the total value of preferred stock issued in the US is about $400 billion. But the market amounts to less than 2% of the total value of American stocks – and the proportion would be smaller had Washington not splashed out $125 billion on preferred stock by bailing out American lenders in 2008.
China is about to introduce preferred stock too. And compared to the relatively slow build-up in the US, its programme will get off to a more frenetic start.
Bank of China became the latest state lender to unveil plans for preferred-share offerings last week. It wants to raise Rmb100 billion ($16 billion), the largest fundraising by a Chinese bank in nearly four years.
Earlier this month Agricultural Bank of China said it wanted to raise Rmb80 billion via preferred stock. Shanghai Pudong Development Bank is also planning a Rmb30 billion issuance.
The funding spree wasn’t possible until recently. In March the China Securities Regulatory Commission (CSRC) issued new rules for a trial programme allowing companies in the Shanghai Stock Exchange 50 A-share Index to issue preferred shares. But it’s the banks that are keenest on the new channel, seeing it as an effective means to replenish core capital. According to IFR Asia, lenders accounting for at least 34% of the index will complete their preferred share issues by mid-year.
Guotai Junan Securities also projects that up to Rmb720 billion of banking shares will hit the market. Real estate developers and energy firms may also tap the new pipeline, so the brokerage expects the preferred share market to grow to as much as Rmb1.37 trillion by 2018, or more than 5% of the stockmarket’s total value.
As a hybrid between a stock and a bond, preferred shares enjoy priority over common shares in the distribution of profits and in event of liquidation. Depending on the terms, buyers generally benefit from higher interest rates (compared with term deposits or coupons on government bonds). But holders also have to be content with limited rights in decisionmaking, unless the preferred stock is converted into ordinary shares.
Regulators were reluctant to approve preferred shares for years, says Shanghai Securities News – for fear of confusing the investing public. “There are also concerns that preferred stocks might exert huge selling pressure in the secondary market if their conversion conditions into common shares are set too loosely,” CBN reckons.
So why open the floodgates now? It seems that capital strength has become a more pressing concern. With less economic growth and more questions about bad debt, banks also need to replenish capital to meet Basel III’s new rules. And with further liberalisation of deposit rates also on the agenda, as well as more competition from newly licenced private-sector banks, the state lenders need to get their houses in order.
More traditional fundraising channels have dried up because of investor fatigue, the Wall Street Journal believes. For instance, Agricultural Bank’s initial public offering in 2010 raised $20 billion. That same year, its banking peers recapitalised with massive right issues too. But many of the investors who coughed up will now be disappointed.
Take Bank of China, which has seen its market capitalisation shrink from Rmb1 trillion in early 2010 to Rmb740 billion of late. Moreover, as the Financial Times points out, even if investors had the appetite for another round of fundraising, the regulations forbid further rights issues when the lender’s stock is trading below book value. Bank of China is now priced at 0.8 times book.
Investor interest in preferred shares may be more fruitful, the Wall Street Journal predicts. State-backed firms, especially insurers, will be willing buyers.
Bank of China has indicated that its own preferred stock will offer interest rates paying up to 7% (versus a dividend yield of about 7.5% on its common stock). So buying preferred stock makes sense if investors anticipate that banks will report slower earnings growth in future, CBN says. The FT seemed to agree. Investors in preferred stock are punting that Chinese banks “will neither enjoy a large equity market rally nor suffer a serious crisis,” it judged.
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