What Is A Preferred Share

Understanding Preferred Shares: A Deep Dive for Investors

Preferred shares, often overlooked in favor of their common stock counterparts, represent a unique investment opportunity with characteristics that blend elements of both debt and equity. This detailed guide will unravel the complexities of preferred shares, explaining their features, benefits, risks, and how they compare to common stock and bonds. Understanding preferred shares can significantly enhance your investment strategy and portfolio diversification.

What are Preferred Shares?

Preferred shares are a class of stock that sits between common stock and debt in a company's capital structure. They represent an ownership stake in a company, but with certain preferential rights over common stockholders. These rights usually relate to dividend payments and asset distribution in the event of liquidation. Think of them as a hybrid security offering a blend of equity and debt characteristics. While they offer less upside potential than common stock, they typically come with a higher degree of stability and priority in dividend payments.

Key Features of Preferred Shares:

Several key features distinguish preferred shares from common stock:

Dividend Preference: This is the most crucial feature. Preferred shareholders are entitled to receive dividends before common shareholders. If a company declares dividends, preferred shareholders get paid first, and only after their dividends are paid are common shareholders eligible for a dividend. The dividend rate on preferred shares is often fixed, offering a predictable income stream. This fixed dividend is usually expressed as a percentage of the share's par value.
Dividend Accumulation: Some preferred shares have an accumulated dividend feature. This means that if the company doesn't pay dividends in a particular period, the unpaid dividends accumulate and must be paid before any dividends are paid to common shareholders. This protects preferred shareholders from dividend cuts.
Liquidation Preference: In the event of a company liquidation or bankruptcy, preferred shareholders have a claim on the company's assets before common shareholders. This priority in asset distribution provides a layer of protection for preferred shareholders.
Voting Rights: Generally, preferred shares have limited or no voting rights in company matters. This is in contrast to common shareholders who typically have voting rights proportional to their share ownership. However, some preferred shares may include provisions granting voting rights under specific circumstances, such as if dividend payments are missed.
Callability: Many preferred shares are callable, meaning the company can redeem (buy back) the shares at a predetermined price after a specified date. This allows the company to reduce its financial obligations and potentially refinance at lower interest rates. This feature can be both a benefit (for the company) and a risk (for the investor).
Convertibility: Some preferred shares are convertible, meaning they can be exchanged for common shares at a predetermined conversion ratio. This offers investors the potential for capital appreciation if the company's common stock price rises.
Par Value: Preferred shares have a stated par value, which is a nominal value assigned to the share at issuance. While the market price of a preferred share can fluctuate, the dividend payments are often tied to this par value.

Types of Preferred Shares:

The world of preferred shares isn't monolithic. There's a variety of types, each with its own nuances:

Cumulative Preferred Shares: These shares have the cumulative dividend feature mentioned earlier. Unpaid dividends accumulate and must be paid before any dividends can be paid to common shareholders. This offers significant protection to the investor.
Non-Cumulative Preferred Shares: These shares do not have an accumulated dividend feature. If the company misses a dividend payment, it's lost and won't be paid later. This carries higher risk for the investor.
Participating Preferred Shares: These shares participate in the company's success beyond the fixed dividend. Once common shareholders receive a specified dividend, participating preferred shareholders may receive an additional dividend payment. This offers greater upside potential.
Non-Participating Preferred Shares: These shares only receive the fixed dividend; they do not participate in additional dividend distributions beyond the predetermined rate.
Redeemable Preferred Shares: These shares can be redeemed (bought back) by the company at a specified price and date. This provides the company with flexibility but can create uncertainty for the investor.
Perpetual Preferred Shares: These shares have no maturity date; they continue indefinitely unless the company redeems them or a specific event occurs.
Adjustable-Rate Preferred Shares: The dividend rate on these shares adjusts periodically based on a benchmark interest rate, such as LIBOR or a Treasury yield. This offers some protection against inflation.

Preferred Shares vs. Common Stock: A Comparison

Feature	Preferred Stock	Common Stock
Dividend Payment	Priority over common stock	Paid after preferred stock (if any)
Voting Rights	Limited or no voting rights	Voting rights proportional to share ownership
Risk	Lower risk than common stock, but higher than bonds	Higher risk than preferred stock, higher potential return
Return Potential	Lower potential return than common stock	Higher potential return than preferred stock
Price Volatility	Less volatile than common stock	More volatile than preferred stock

Preferred Shares vs. Bonds: A Comparison

Feature	Preferred Stock	Bonds
Ownership	Represents ownership in the company	Represents a loan to the company
Dividend Payment	Dividends (not guaranteed)	Interest payments (usually guaranteed)
Priority	Higher priority than common stock in liquidation	Higher priority than preferred stock in liquidation
Maturity	Usually perpetual or callable	Has a specific maturity date
Tax Treatment	Dividends may be taxed differently than interest	Interest payments are usually tax-deductible for the company

Advantages of Investing in Preferred Shares:

Higher Dividend Yield: Preferred shares often offer a higher dividend yield compared to common stock and some bonds. This provides a predictable income stream.
Lower Risk than Common Stock: Because of their priority in dividend payments and liquidation, preferred shares generally carry lower risk than common stock.
Protection Against Inflation (for some): Adjustable-rate preferred shares can offer some protection against inflation, as their dividend rate adjusts with interest rate changes.
Diversification: Adding preferred shares to your investment portfolio can offer diversification benefits, reducing overall portfolio risk.

Disadvantages of Investing in Preferred Shares:

Lower Return Potential than Common Stock: The fixed dividend payment limits the upside potential compared to common stock, which can experience significant price appreciation.
Callability Risk: If the company calls the shares, you may receive only the call price, potentially missing out on future dividend payments.
Interest Rate Risk: Changes in interest rates can impact the market price of preferred shares, particularly adjustable-rate preferred shares.
Less Liquidity: Preferred shares are generally less liquid than common stock, meaning it may be more difficult to buy or sell them quickly.

How to Analyze Preferred Shares:

Analyzing preferred shares involves a slightly different approach than analyzing common stock. Key factors to consider include:

Dividend Yield: Calculate the dividend yield (annual dividend/share price) to compare it to other investment options.
Credit Rating: If available, check the company's credit rating to assess the risk of default.
Call Provision: Understand the call provision (call price and date) to assess the potential for early redemption.
Conversion Feature (if applicable): Analyze the conversion feature, considering the conversion ratio and the potential for future price appreciation of the common stock.
Market Price and Valuation: Compare the current market price to the par value and consider the relationship between the dividend yield and the prevailing interest rates.

Frequently Asked Questions (FAQ)

Q: Are preferred shares a good investment? A: Whether preferred shares are a "good" investment depends on your individual investment goals and risk tolerance. They offer a balance between stability and income, but with limited growth potential.
Q: How are preferred shares taxed? A: The tax treatment of preferred stock dividends varies depending on your jurisdiction and the specific type of preferred shares. Consult a tax professional for detailed guidance.
Q: Where can I buy preferred shares? A: Preferred shares can typically be purchased through online brokerage accounts, similar to common stocks.
Q: What are the risks of investing in preferred shares? A: Key risks include interest rate risk, call risk, and the lower potential for capital appreciation compared to common stock.
Q: Can preferred shareholders vote? A: Generally, no, but some preferred shares may have voting rights under certain circumstances, such as if dividends are missed.

Conclusion:

Preferred shares offer a distinct investment opportunity, providing a blend of stability and income. They are a valuable tool for portfolio diversification and can be particularly attractive to income-seeking investors. However, understanding their unique features, risks, and limitations is crucial before investing. By carefully considering the various types of preferred shares and conducting thorough due diligence, you can make informed decisions that align with your overall investment strategy. Remember to always consult with a financial advisor before making any investment decisions. This article provides a comprehensive overview, but individual circumstances and market conditions should always be considered.