What Is A Preferred Share

Understanding Preferred Shares: A Comprehensive Guide for Investors

Preferred shares, often simply called "preferreds," are a type of stock that sits between common stock and debt in a company's capital structure. They offer investors a blend of characteristics from both, providing a potentially attractive investment opportunity with unique risks and rewards. This comprehensive guide will explore what preferred shares are, how they work, their advantages and disadvantages, and ultimately help you determine if they're the right addition to your investment portfolio.

What are Preferred Shares?

Preferred shares represent an equity ownership in a company, but unlike common stock, they generally don't carry voting rights. This means preferred shareholders typically don't get a say in the company's governance or strategic decisions. However, they are prioritized over common shareholders in terms of dividend payments and asset distribution in the event of liquidation. Think of them as a hybrid instrument – combining features of both debt and equity.

Key Characteristics of Preferred Shares:

• Dividend Priority: Preferred shareholders receive dividends before common shareholders. This doesn't guarantee dividends, however, as the company's performance will determine if dividends are paid at all.
• Limited Voting Rights: Most preferred shares have limited or no voting rights. This is a key differentiator from common stock, where shareholders typically have voting power proportional to their share ownership.
• Fixed Dividend Rate: Many preferred shares offer a fixed dividend rate, providing a more predictable income stream than common stocks. This fixed rate can be expressed as a percentage of the share's par value or as a dollar amount per share.
• Cumulative Dividends: Some preferred shares have a cumulative feature. This means that if dividends are not paid in a given period, they accumulate and must be paid before any dividends can be distributed to common shareholders.
• Redemption or Call Features: Some preferred shares are callable, meaning the issuing company can buy them back at a predetermined price after a specific date. This gives the company flexibility, but it also presents a risk to the investor as their investment might be prematurely terminated.
• Liquidation Preference: In the event of a company's liquidation or bankruptcy, preferred shareholders are typically paid before common shareholders. However, they are generally paid after debt holders.

How Preferred Shares Work: A Deeper Dive

The mechanics of preferred shares are relatively straightforward. Investors purchase preferred shares at the market price, just like common stock. The issuer – typically a corporation – then pays dividends to preferred shareholders according to the terms specified in the share's prospectus. These dividends are usually paid quarterly, but this can vary depending on the specific terms of the issue.

The dividend rate is often fixed, offering a relatively predictable income stream. However, it's crucial to remember that dividend payments are not guaranteed. If the issuing company experiences financial difficulties, it may choose to suspend or reduce dividend payments. This is where the "cumulative" feature becomes important. If the preferred shares are cumulative, any missed dividends will accumulate and must be paid before common shareholders receive anything.

The redemption or call feature introduces a level of uncertainty. The company has the option to repurchase the preferred shares at a specific price after a designated date. This provides the company financial flexibility but can disrupt an investor’s long-term plans. The call price is typically set at a slight premium to the original purchase price.

Let's illustrate with a simple example. Suppose you purchase 100 shares of a preferred stock with a par value of $25 and a dividend rate of 6%. Your annual dividend would be 100 shares * $25/share * 6% = $150. This would typically be paid out in four quarterly installments of $37.50.

Advantages of Investing in Preferred Shares

Preferred shares offer several compelling advantages to investors:

• Higher Dividend Yield: Preferred shares often offer a higher dividend yield compared to common stocks, providing a relatively stable income stream. This is particularly attractive to income-focused investors.
• Priority over Common Stock: In the event of liquidation or bankruptcy, preferred shareholders have priority over common shareholders in receiving their share of assets. This provides a higher level of security, though still lower than debt holders.
• Lower Volatility than Common Stock: Generally, preferred shares exhibit lower price volatility than common stocks. This makes them a potentially less risky investment option, particularly during periods of market uncertainty.
• Potential for Capital Appreciation: While not the primary goal for many preferred stock investors, the market price of preferred shares can appreciate, providing additional returns beyond dividends. However, this appreciation is less common than with common stock.

Disadvantages of Investing in Preferred Shares

Despite their advantages, preferred shares also carry some disadvantages:

• Lower Return Potential: Compared to common stock, the potential for capital appreciation is usually lower for preferred shares. Their returns are more tied to the dividend payment.
• Dividend Risk: Although preferred shares have dividend priority, dividend payments are not guaranteed. Companies facing financial difficulties may suspend or cut dividends.
• Call Risk: Callable preferred shares present the risk of being redeemed by the issuing company before the investor's desired holding period. This can disrupt investment strategies and limit long-term returns.
• Sensitivity to Interest Rates: The value of preferred shares can be sensitive to changes in interest rates. When interest rates rise, the relative attractiveness of the fixed dividend payment decreases, potentially leading to a decline in the share price.
• Limited Voting Rights: Preferred shareholders typically lack voting rights, meaning they have less influence over the company's management and strategic direction compared to common shareholders.

Different Types of Preferred Shares

Preferred shares aren't a homogenous group; they come in various types with different features and characteristics. Some of the most common types include:

• Cumulative Preferred Shares: As mentioned earlier, these shares have accumulated dividends, meaning unpaid dividends accumulate and must be paid before any dividends are paid to common shareholders.
• Non-Cumulative Preferred Shares: Unpaid dividends are not accumulated. If the company skips a dividend payment, it's lost.
• Participating Preferred Shares: These shares allow holders to receive dividends in addition to the stated preferred dividend if the company performs exceptionally well. This adds a potential upside beyond the fixed dividend rate.
• Non-Participating Preferred Shares: These shares only entitle holders to the stated preferred dividend, regardless of the company's performance.
• Callable Preferred Shares: The company has the option to redeem (buy back) these shares at a predetermined price and date.
• Convertible Preferred Shares: These shares can be converted into common stock at a predetermined conversion ratio, offering investors the potential for greater returns if the common stock price appreciates significantly.
• Redeemable Preferred Shares: These shares can be redeemed by the investor at a predetermined price and date. This provides the investor with some control over their investment.

Preferred Stock vs. Common Stock: A Comparison

The key differences between preferred and common stock are summarized in the table below:

Feature	Preferred Stock	Common Stock
Dividend Priority	Before common stockholders	After preferred stockholders
Voting Rights	Typically limited or none	Typically proportional to shares
Dividend Rate	Usually fixed	Variable
Liquidation	Priority over common stockholders	After preferred stockholders
Risk	Generally lower than common stock	Generally higher than preferred stock
Return Potential	Lower than common stock	Higher than preferred stock

Preferred Shares: A Part of a Diversified Portfolio?

Whether preferred shares are a suitable investment for you depends on your individual investment goals, risk tolerance, and overall portfolio strategy. They can be a valuable addition to a diversified portfolio, particularly for income-focused investors seeking a relatively stable income stream and lower volatility than common stocks.

However, it's crucial to understand the potential risks, including the possibility of dividend cuts or the call feature. Thorough research and a careful evaluation of your financial situation are essential before investing in preferred shares.

Consider consulting with a financial advisor to determine if preferred shares align with your investment objectives. They can help you assess your risk tolerance and incorporate preferred shares appropriately into your broader investment strategy.

Frequently Asked Questions (FAQs)

Q: Are preferred shares safer than common shares?

A: Generally, yes. Preferred shares offer a degree of safety through their priority in dividend payments and asset distribution during liquidation. However, they still carry risk, especially concerning dividend cuts and call risk.

Q: How are preferred shares taxed?

A: The tax treatment of preferred shares varies depending on your jurisdiction and the specific features of the shares. Dividends from preferred shares are generally taxed as ordinary income. Capital gains or losses are taxed as capital gains or losses, depending on whether the shares were sold at a profit or loss. Consult a tax professional for specific guidance.

Q: Where can I buy preferred shares?

A: Preferred shares can be purchased through most brokerage accounts, similar to common stock. Many online brokerage platforms offer access to a wide range of preferred shares.

Q: Are preferred shares suitable for all investors?

A: No. Preferred shares might not be suitable for all investors, particularly those seeking high growth potential. Their returns are more moderate and focused on income. Consult with a financial advisor to determine suitability.

Q: What are some of the risks of investing in preferred shares?

A: The main risks include dividend cuts, call risk (the company buying back the shares), interest rate sensitivity, and lower potential for capital appreciation compared to common stocks.

Q: How do I research preferred shares before investing?

A: Research should focus on the issuing company’s financial health, the specific terms of the preferred shares (dividend rate, call features, etc.), and the overall market conditions. Review financial statements, credit ratings, and any available research reports.

Conclusion: Making Informed Decisions About Preferred Shares

Preferred shares present a unique investment opportunity with a blend of equity and debt characteristics. While they offer the potential for a stable income stream and lower volatility than common stocks, they also come with inherent risks, particularly concerning dividend cuts and call features. Understanding these advantages and disadvantages is crucial for making informed investment decisions. Thorough research and, potentially, consultation with a financial advisor, are vital steps before incorporating preferred shares into your portfolio. By carefully evaluating your risk tolerance and investment objectives, you can determine if preferred shares are the right fit for your financial goals. Remember, diversification is key to any successful investment strategy.