Franking credits can hurt investors

Franking credits can hurt investors

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We all love the additional return that franking credits give us on top of dividend payments, but are they always a good thing?

Most of the recent hybrid issues offer a floating rate which is the bank bill rate (“BBR”) plus a margin. For example, the heavily oversubscribed Commonwealth Bank (ASX: CBA) PERLS VI offered the three-month BBR+3.8%, Westpac (ASX: WBC) preference shares used the six-month BBR+3.25%, and ANZ (ASX: ANZ) preference shares used the six-month BBR+3.1%. But these three, and many others, include franking credits as part of the payments. This is a聽disadvantage for聽investors for two reasons.

First, the practical reason. The franking credits are not on top of the interest rate quoted, they are part of it and the cash payment into your bank is thereby reduced. If the nominal interest rate was 7.4%, then you would get 5.18% per annum paid quarterly. The other 2.22% either comes off your tax bill at the end of the year, or perhaps makes up part of a tax refund depending on your particular circumstances. A cash payment on time of the full amount would be worth more since you could reinvest it, and for overseas investors, it would be worth much more since they can’t use the franking credits at all.

Second, the theoretical reason. Franking credits are only available to companies that have paid tax on their profit and are distributing part of that profit to shareholders. If a company is paying interest on borrowed money, it can’t pay franking credits on those payments —聽rather these are costs which are deducted in order to calculate profit. If a hybrid comes with franking credits, the payments are coming out of the post-tax profit and the hybrid is absolutely part of the equity base of the company, certainly in the regulator’s or tax office’s view.

Foolish takeaway

Hybrids are often marketed as somehow equivalent to fixed interest, but they are not, especially if they come with franking credits. As always, you need to understand what you are investing in.

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Motley Fool contributor Tony Reardon owns shares in Commonwealth Bank and ANZ, but does not own the hybrids discussed. The Motley Fool‘s聽purpose is to help the world invest, better.聽Take Stock聽is The Motley Fool鈥檚聽free聽investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.聽Click here now聽to request聽your free subscription, whilst it鈥檚 still available.聽This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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