A beginner's guide to bonus shares
Bonus shares are those you don't pay for.
So how exactly do they work?
Here is your beginner's guide to bonus shares.
What are bonus shares?
Shareholders receive bonus shares in two main ways. One is through a listed company's bonus share plan (BSP) where you can receive bonus shares, usually twice yearly, in lieu of receiving cash dividends.
Bonus share plans are thus an alternative to dividend reinvestment plans (DRPs), which also put shares in your hands rather than dividends but are far less common than DRPs and can have different tax implications for investors. More on this later.
The other way of receiving bonus shares is through a one-off company issuance where every person holding its shares at a specified date receives a number of bonus shares, at no charge, determined by the number of ordinary shares they already hold.
For example, you may receive one free bonus share for every five ordinary shares you already have - in which case it would be known as a "one for five bonus issue".
Free shares - what is the catch?
Free shares sound great, and appear an incredible act of generosity on the part of the company and a wonderful benefit to the shareholder.
However, Greg Canavan, the editor of shares newsletter Sound Money Sound Investments is not convinced: "Receiving bonus shares gives you the impression of increasing your ownership in a company but, if everyone gets the same bonus deal, it doesn't change your level of ownership relative to any other shareholder.
If all shareholders get, say, 20% more shares, no one's better off. "It's also hard to see an economic benefit to the company."
What do bonus shares mean for the share price?
What a bonus issue does, at least in theory and at the time of issuance (but perhaps not some time afterwards), is lead to a share price fall reflecting the greater number of shares now on issue - assuming the company's fundamentals (profitability, assets, management and so on) remain unchanged.
For example, a one-for-one bonus issue, where the number of shares on issue doubles, should lead to a new share price that's half the pre-bonus price. While you might now hold twice as many shares in the company as before the bonus issue, their individual price has theoretically fallen 50% and the total value of your holding should be the same as before the bonus issue.
What are the benefits?
There may be some real benefits to shareholders in due course from an issue. According to the late Nick Renton in his classic book Understanding the Stock Exchange, because the bonus issue immediately depresses the share price, some smaller investors who were put off by the previous higher price may be inclined to invest at the new, seemingly more affordable price.
As irrational as this is, increased small investor interest and activity can drive the share price up.
Furthermore, Renton adds, if the bonus ratio is low, say one for 10, the price fall will not be large and the after-bonus price may creep back up to the pre-bonus price - because people were used to that price level and have forgotten that the share dilution has taken place. In such cases, the bonus shares eventually can increase the shareholder's wealth.
How common are bonus share plans?
As for bonus share plans, an alternative to the far more common dividend reinvestment plans, they're very rare.
Because bonus shares under tax law acquire the status of the original shares they relate to, if the original shares were acquired pre-September 20, 1985 and therefore pre-capital gains tax, any bonus shares flowing from them are also deemed pre-1985 and free of CGT.
For shareholders with pre-1985 shares, bonus share plans are therefore a winner. For holders of post-1985 shares - most share investors - Renton says bonus s hares result in a worse capital gains tax liability than under a dividend reinvestment plan, though they may lead to a better immediate income tax saving.
Definitely discuss the matter with your accountant before making a choice.
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