SIMON BROWN: The tricks of income investing

Income investing has two main challenges, the first being return (yield) and the second tax. 

Tax is perhaps the bigger challenge. The issue is that interest received is added to your income above the tax-free threshold of R23,800 for people under 65 and R34,500 for those over 65. These exclusion levels are generally not a problem until you start getting serious about interest income. But then the limits can get hit fairly quickly, which means you end up being taxed at your marginal tax rate. 

One solution has been the CoreShares Preference Share exchange traded fund (ETF), which has offered good yield (linked to prime) and tax efficiency. The better tax treatment was because preference shares pay dividends that are taxed at 20%, which is potentially lower than your marginal rate, saving you tax. 

But this ETF is being delisted at the end of May. The reason is that preference shares are no longer considered tier 1 capital for banks under the Basel 3 international bank regulatory framework. As tier 1 capital they were an attractive source of debt for the banks, but this has been phased out, and since the end of 2022 they have no longer been tier 1. This has made the preference share market dry up, with no new listings in years; instead, many are now being delisted by the issuers. 

So, what are the alternatives? 

In the case of CoreShares, it plans to issue a new government bond ETF, and holders of the preference share ETF will automatically be moved into this new ETF. But, as with many other bond ETFs on the JSE, the issue for investors again becomes tax, as the distributions are interest, and any interest higher than the exclusions mentioned above are taxed at your marginal rate. 

One solution here is to use a tax-free account in which any interest received is tax free. But the lifetime limit of R500,000 and the annual limit of R36,000 mean you likely don’t have that much in your tax-free account yet. In time our tax-free accounts will become chunky, but that is decades away. 

An investor could elect to create their own preference share portfolio directly by buying some of the prefs in their brokerage account. The CoreShares ETF held preference shares from Standard Bank and Absa at above 20% each, with the Investec prefs at about 15%. Then it had a bunch of smaller ones from Discovery, Invicta, Netcare and Grindrod. A private investor who has fewer liquidity issues thanks to the smaller positions they invariably have in these instruments could boost these four to enhance yield. 

Property stocks or ETFs are also a consideration. Here again, however, distributions are taxed as income, so we don’t solve the tax issue and we have the very real risk of capital loss. 

Unfortunately, in a nutshell, the demise of the preference share market under the new Basel 3 rules leaves local investors without a great tax-efficient way to generate yield. 

But have a look at an individual preference share portfolio, spread the risk across a few different shares and you should still get a decent yield and some tax efficiencies.