Preference Shares

Introduction

Preference shares, also known as preferred stock, are a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares typically come with dividends that must be paid out before dividends to common shareholders and usually do not have voting rights. They are a hybrid form of financing, offering a mix of the characteristics of equity and debt, making them a distinct choice for both the issuing company and the investor.

Characteristics of Preference Shares

Dividend Priority

Preference shareholders receive dividend payments before common shareholders. These dividends are often fixed and may accumulate if not paid when due, a feature known as cumulative preferred stock. This priority in dividends makes preferred shares an attractive investment for those seeking a steady income stream.

Fixed Dividend Rate

Most preference shares deliver a fixed dividend rate, similar to the fixed interest on bonds. This rate is typically stated when the shares are issued, and it doesn’t change. The fixed nature of these dividends provides a predictable income for investors.

Capital Repayment Priority

In the event of liquidation or bankruptcy, preference shareholders have a higher claim on the assets of the company than common shareholders. This partially offsets the risk of investing in equity, providing a cushion against potential losses.

Convertibility

Some preference shares come with the option to be converted into a fixed number of common shares, either at the option of the shareholder or automatically at a specific time. These convertible preferred shares give investors the potential to benefit from the upside movement of the company’s common stock.

Non-Voting Rights

Generally, preference shareholders do not have voting rights in the company’s AGM (Annual General Meeting). However, if dividends have been in arrears for some time, these shareholders might attain temporary voting rights until their dividends are brought back to par with the cumulative arrears.

Callable Feature

Callable preferred shares give the issuing corporation the right to repurchase the shares at a specified price after a certain date. This feature allows the company flexibility to refinance if conditions are more favorable or if they choose to retire the shares.

Types of Preference Shares

Cumulative Preference Shares

These shares come with the benefit of accumulating dividends. If the issuing company skips a dividend payment, it must pay it in the future alongside regular dividends before any can be distributed to common shareholders.

Non-Cumulative Preference Shares

Non-cumulative preference shares do not accumulate unpaid dividends. If a dividend is skipped, the shareholder does not have the right to claim it in the future.

Participating Preference Shares

Participating preferred shareholders have the right to receive dividends equal to the amount that holders of common shares receive, in addition to the fixed preferential dividend. They also share in the distribution of surplus assets during liquidation, after all debts and other claims are settled.

Convertible Preference Shares

These shares allow investors to convert their preference shares into a predetermined number of common shares, usually at the discretion of the shareholder.

Perpetual Preference Shares

These shares have no fixed redemption date. They require the issuer to pay dividends indefinitely, or until they decide to call (repurchase) them, if the shares are callable.

Benefits of Preference Shares

Income Stability

The fixed dividend feature provides a stable and predictable income stream, which is especially appealing to retirees and income-focused investors.

Priority in Dividends and Liquidation

Preference shareholders enjoy prioritization in dividend payments and asset distribution during liquidation, reducing their downside risk compared to common shareholders.

Tax Advantages

In some jurisdictions, dividends received from preference shares may be taxed at a lower rate than other forms of income, making them an attractive investment from a tax perspective.

Diversification

Preference shares can offer a diversification benefit to investors, as they provide exposure to corporate finance mechanisms that differ from common equity and bonds.

Drawbacks of Preference Shares

Limited Upside Potential

The fixed dividend rate limits the potential for capital appreciation seen with common shares.

Interest Rate Sensitivity

Like bonds, the value of preferred shares can be negatively affected by rising interest rates. As rates rise, newer issues may offer higher dividends, making existing lower-yield shares less attractive.

Missed Voting Rights

The lack of voting rights can be a significant drawback for investors looking to have a say in the company’s strategic decisions.

Credit Risk

While preferred shares are generally safer than common shares, they still face credit risk. The issuing company may encounter financial difficulties that affect its ability to pay dividends.

Preference Shares vs. Common Shares

Understanding the key differences between preference shares and common shares is crucial for making an informed investment decision.

Dividends

Preference Shares: Have a fixed dividend rate, higher priority in dividend payments.
Common Shares: Dividends vary and are paid after preference shareholders.

Voting Rights

Preference Shares: Generally no voting rights.
Common Shares: Have voting rights, allowing shareholders to influence management decisions.

Risk and Capital Appreciation

Preference Shares: Lower risk due to fixed dividends and priority in liquidation but limited potential for capital appreciation.
Common Shares: Higher risk with no fixed dividend but greater potential for capital appreciation.

Issuance of Preference Shares

Corporate Reasons for Issuing

Corporations issue preference shares for a variety of strategic reasons:

Raising Capital without Diluting Control: Preference shares can provide significant capital influx without diluting the control of existing common shareholders. This is especially appealing for company founders or family-owned businesses.
Financial Structuring: Preference shares can be used to optimize a corporation’s capital structure. By having a blend of debt, common equity, and preferred equity, companies might achieve a more advantageous cost of capital and risk profile.
Flexibility: Issuing callable preference shares provides companies with the flexibility to manage their capital structure. They can repurchase shares if they have excess cash or if interest rates decline, making debt cheaper than equity.

Steps in Issuance

Board Approval: The proposal to issue preference shares must first be approved by the board of directors.
Shareholder Approval: Depending on the jurisdiction, issuing preference shares may require a vote by existing shareholders.
Regulatory Compliance: Comply with securities regulation and other legal requirements which may include filing with the Securities and Exchange Commission (SEC) or other local regulatory bodies.
Setting Terms: Determining the specifics, such as dividend rates, call provisions, convertibility options, and whether the shares will be participating or non-participating.
Marketing and Sale: The shares are then marketed to potential investors through channels such as investment banks or brokers.

Preference Shares in Financial Markets

Exchange-Traded Preferred Shares

Many preference shares are traded on major exchanges like the New York Stock Exchange (NYSE) or NASDAQ. This trading provides liquidity to investors who can buy or sell these shares just like common stock.

Credit Ratings

Credit rating agencies such as Moody’s, S&P, and Fitch rate preference shares, providing an assessment of the issuing company’s creditworthiness. Higher-rated issues are generally considered safer and thus offer lower dividend yields.

Investment Options

Institutions may offer funds or ETFs that focus on preferred shares, providing a convenient method for individual investors to gain broad exposure without having to select specific preferred shares.

Regulatory and Tax Considerations

Regulatory Framework

The issuance and trading of preference shares are regulated by securities laws to protect investors and maintain fair markets. Companies must comply with ongoing disclosure requirements, including quarterly and annual financial statements.

Tax Treatments

In many jurisdictions, dividends from preference shares have unique tax treatments:

Corporate Investors: In some regions, dividends received by corporations are subject to a lower tax rate expressed as the Dividends-Received Deduction (DRD).
Individual Investors: May benefit from preferential tax rates on qualified dividends, though specific regulations vary by country.

Understanding the tax implications is vital for investors, affecting the net yield and investment attractiveness of preference shares.

Conclusion

Preference shares offer a unique blend of characteristics, providing steady dividends with a higher claim on assets than common shares. They are valuable tools in corporate finance for raising capital and optimizing financial structure while offering investors an income-producing alternative to bonds. However, they come with limitations, including capped upside potential and lack of voting rights. Understanding the detailed features, benefits, drawbacks, and regulatory landscape of preference shares can help both investors and corporations make informed decisions.

For further details on managing and investing in preference shares, companies such as Vanguard and Fidelity provide comprehensive resources: