Preferred Shares – Everything You Need to Know

What are Preferred Shares?

A corporate balance sheet divides into sections for assets, liabilities, and stockholders’ equity. The equity section records the accumulated profits, or retained earnings, of the firm, along with the proceeds from the sale of common and preferred stock shares. Preferred stock combines features of bonds and common stock. They typically don’t have any voting rights. Preferred shares pay relative high dividends that compete with bond interest for the attention of income-oriented investors. A corporation must pay all of its current preferred dividends before paying any dividends on common stock. If the preferred is cumulative stock, the corporation must pay any omitted preferred dividends before resuming common stock payouts. If the company goes bankrupt, preferred shares repay ahead of common shares. Preferred stocks has fixed dividends, which helps to stabilize the price of preferred shares.

Common Shares vs Preferred Shares

Both kinds of shares represent an ownership interest in the corporation, and both can pay dividends, yet each has several unique features that distinguish it from its equity partner. All public corporations issue common stock, but preferred shares are strictly optional.

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Purposes

Common stock exists to distribute ownership of a corporation to a wide population of shareholders. Corporation use the cash raised by issuing common stock for investments, asset purchases, operations and to pay off debt. Common stockholders realize their portions of company earnings through share price appreciation and dividends. Corporations issue preferred stock also to raise cash, but the target buyers are interested only in dividends, not capital gains from price appreciation. Preferred shares offer dividend rates that compete with bond interest rates. Share prices are usually very stable. However, if interest rates rise, preferred shares may suffer price declines as they become less attractive income sources.

Claims

If a company goes bankrupt and must liquidate, the proceeds first distribute to the government and to creditors. Preferred shareholders are next in line, followed by common stockholders. Companies that issue multiple series of preferred shares designate a pecking order for liquidation proceeds. Preferred dividends have first claim on retained earnings, the source of all dividend payments. A corporation can’t distribute common stock dividends unless it has paid all of the preferred dividends first.

Variations

Corporations are allowed to issue only one type of common stock. All shares are equal: they have equivalent claims on earnings and share equally in any dividend payments. Preferred stock is another story. Companies can issue multiple types of preferred, each with its own dividend rate. Convertible preferred shares can exchange for a fixed number of common shares, which can have the effect of dragging the price of preferred shares higher as common stock prices rise. Cumulative preferred stock must repay any missed dividends before common dividends can pay.

Options, Options

Common stock is like plain vanilla ice cream — it is a straightforward financial instrument with no surprises. Preferred shares are more like tutti-frutti, in that they can be issued with a number of different options. We’ve already mentioned preferred shares that can convert optionally to common stock. The issuing corporation can redeem “callable” preferred for a predetermined price on or after one or more call dates. “Putable” preferred shareholders can force the corporation to buy back the shares, once again at a preset price. The put option is valuable, as it protects preferred shareholders from a price decline if interest rates rise.

Important Features

Appreciation

Corporations issue preferred stock to raise money. Since preferred stock is not debt, the money raised does not have to repay. Preferred shares provide higher dividends than do common shares, but they don’t gain value from the growth of the issuing company, because unlike common dividends, preferred dividends normally never change. Preferred shares trade like bonds, based on a fixed return. Under certain circumstance, preferred stock can appreciate in value.

Preferred stock is a hybrid of equity and debt. Preferred dividends pay cash amounts similar to the interest that long-term bonds pay. However, preferred stock is equity on the corporate balance sheet. Many corporations issue preferred stock with maturity dates. At maturity, the stock retracts for a cash amount, called the face value or par amount of the stock. Therefore, as a retractable preferred stock approaches its maturity date, it is not likely to appreciate beyond face value.

Interest Rates

Preferred shares react to changes in interest rates much like bonds do. When interest rates fall, the prices of preferred shares rise due to their now relatively generous yield. For example, a share of preferred stock selling for $100 might pay an annual dividend of $6. If prevailing interest rates fall from 6 percent to 5 percent, the price of the preferred stock would rise to $120 to also yield 5 percent. A share owner could reap a gain of $20 per share, but only if the issuer doesn’t first call the shares.

Tax Differences

In the United States, the payouts from bonds, including perpetual ones, are interest, taxable as ordinary income. Stock dividends normally qualify for long-term capital gains tax rates, which vary from 20 percent to 0 percent, depending on your gross income. Bonds and stocks can provide capital gains or losses when you sell them. To get the benefit of the long-term capital gains rates, you must hold the security for more than one year. Otherwise, gains are taxable at your marginal tax rate.

Bankruptcy

Some corporations fail. They go into bankruptcy and liquidate — sold off for cash. The resulting cash must go to a wide variety of interested parties. The pecking order for liquidation proceeds starts with the government, followed by creditors, preferred shareholders and finally common stockholders. From this list, it would appear that preferred shareholders have an intermediate chance of reimbursement for their now-worthless stock. However, statistics show that the chances of preferred shareholders receiving a meaningful reimbursement are remote.

Failure to make timely payments of bond interest can force the court to declare bankruptcy and order the company’s liquidation. The assets of the company go up for auction under the supervision of a court-appointed liquidator.

Preferred shares pay a dividend rate that competes with bond interest. However, preferred share dividends can suspend without causing any sort of default. When a preferred stock misses a dividend payment, the corporation must withhold any dividends to common stockholders. Cumulative preferred stock goes a step further and requires that all previous missed dividends pay before common stockholders can receive dividends.

Recovery

Although preferred shares have a prior claim on liquidation proceeds relative to the claims of common stockholders, the actual chance of preferred shareholders receiving any of the liquidation proceeds is not good. Moody’s published a study in 2009 showing the recovery rates of preferred shareholders from 1920 through 2008 was only 13.1 percent of the preferred stock’s value before bankruptcy. In other words, the company creditors gobbled up the vast majority of the proceeds from liquidation, leaving little for the preferred stockholders to share.

investors can always sell your preferred shares if you hear a company is experiencing difficulties, but the chances are that the market price of the shares has already dropped considerably. Still, you can avoid a total loss this way. A better solution is to purchase only “putable” preferred shares. These are shares that give you the right to force the company to buy back your shares from you for a pre-established price. This right must exercise before the company enters bankruptcy, and other constraints on its use may exist, so study the share prospectus.

Types of Preferred Shares

Convertible Preference Stock

Investors can convert convertible preferred shares into a specified number of common shares. This linkage between common and preferred stock boosts preferred share prices when common stock prices rise.

The ratio and the prices of the company’s preferred and common shares produce a “conversion price” — the common stock price that makes conversion profitable. Corporations invariably issue convertible preferred with a conversion price that is well below the current common stock price. Unless the common stock blasts off, convertible preferred share prices reflect prevailing

Preferred stockholders profit from preferred share conversion when common shares becomes more valuable than preferred shares. This occurs at the conversion price. As common stocks cross the conversion price threshold, preferred shares rise in lockstep with the common shares. However, the issuer may call preferred shares rather than convert them, which once again limits capital appreciation.

Corporations can issue convertible shares at a slight discount to identical non-convertible shares because investors are willing to accept less yield in exchange for the conversion “lottery ticket. Just when the party gets interesting, the issuing corporation might take away the punch bowl by calling the preferred shares.

Conversion Effect

Suppose XYZ Corp issues convertible preferred stock with a conversion price of $35. To make the conversion profitable, the common shares currently trading for $17.50 must double in price. As the common stock price approaches the conversion price, the price of the convertible preferred shares start to rise, thereby lowering their dividend yield — the annual dividend amount divided by the share price. Once the common stock crosses the conversion price, investors start exchanging their preferred shares for common stock.

Redeemable Preference Stock

Most corporations embed call options in their preferred stock. These options permit the corporation to forcibly redeem its shares on or after the call date for a preset price. Both perpetual and nonperpetual preferred shares can be redeemable (callable). Corporations call preferred shares when interest rates fall and reissue new, lower-yield preferred stock. This little trick helps the corporation conserve money but deprives shareholders of their anticipated dividends.

The call price is usually a little higher than the face value of the shares. For example, if shares have a face value of $100 each, they might call for $101. Corporations call preferred stock when interest rates fall. In addition, corporations tend to call redeemable convertible preference shares when conversion becomes profitable. If they didn’t call the shares, the corporation would be subsidizing the discounted sale of its common stock.

A corporation might replace preferred shares with a new preferred issue having a lower dividend yield. In this way, corporations conserve earnings that they would otherwise spend on higher dividends. Owners of callable preferred don’t reap any capital appreciation beyond that garnered at the call price.

Cumulative Preferred Stock

Preferred shares may be cumulative or noncumulative — this feature is unrelated to whether they are redeemable convertible preference shares. Corporations must pay all preferred share dividends for the current period before distributing common stock dividends. By default, preferred shares are noncumulative — if the corporation misses a dividend payment, it doesn’t have to make good on that payment later on. Cumulative shares require that corporations pay all current and missed preferred dividends before resuming dividends on common shares. Investors value cumulative shares, which makes them a more expensive than equivalent noncumulative shares.

Retractable Preferred Stock

Preferred stock issued without a maturity date is “perpetual”, whereas “retractable” preferred shares have a finite lifetime. Retractable (or nonperpetual) preferred stock carries a maturity date. On that date, a corporation cancels the preferred shares and pays shareholders a fixed redemption price per share — usually the original issue price. The corporation also forks over any pending dividends on the maturity date. Maturity dates usually range from five to 30 years into the future. Because of the retraction feature, a preferred stock’s price converges on its redemption price as the maturity date approaches.

If you hold a nonperpetual preferred stock to maturity, you are immune from the stock’s price fluctuations over its lifetime. On the other hand, perpetual preferred stock prices may suffer long-term damage if interest rates rise and stay high.

Retractability is another feature that the corporation must specify in the stock’s prospectus. Retractable shares might also be redeemable before the maturity date. The stock prospectus may specify a “soft” retraction in which the corporation retains the right to pay for the retracted shares with common stock rather than cash. If the corporation pays for the retraction with common stock, it normally issues common shares worth 95% of the preferred stock’s value at current market prices.

Floating-Rate Retractable Preferred Shares

Corporations usually issue preferred shares that have a fixed dividend. Like fixed-interest bonds, fixed-dividend preferred stock is subject to interest rates risk. If interest rates rise, investors bid down the prices of existing fixed-payment securities in favor of newer, higher-return issues. A floating preferred stock has an adjustable dividend that periodically adjusts to prevailing interest rates. Such issues have stable prices compared to fixed-dividend issues. Floating rate preferred shares may be retractable or perpetual.

Putable Preferred Shares

Corporations often attach a “put option” to retractable preferred shares. This option gives the shareholder the right to put, or sell, the shares back to the corporation for a preset price. The put option places a minimum price floor under the preferred shares, an attractive feature to shareholders. Put options can also embed in perpetual preferred stock shares. Indeed, corporations can mix and match many different features into perpetual preferred stock. For example, in addition to the features already mentioned, “convertible” preferred shares can convert into shares of common stock at the shareholder’s request.

Exchangeable Preferred Stock

Exchangeable preferred stock is similar to convertible preferred. The only difference is that, upon conversion, the issuer may provide shares in another corporation. A mandatory exchangeable security is an exchangeable security that exchanges automatically for the underlying common stock or cash.

Investing in Trust Preferred Securities

If you’re craving some unusual investments to spice up your portfolio, you might want to consider trust preferred securities, or trups. They were once the darlings of the banking industry until Congress changed the rules on how they operate. While less popular today, you can still buy them, but you will benefit by first understand their unique risks.

Trups 101

Trups are hybrids between preferred stock and debt. Banks and other large issuers create them by first setting up a trust company. The bank issues a long-term bond to the trust, which becomes the trust’s only asset. Investors then buy the trust’s preferred shares and receive quarterly distributions of the income generated by the trust’s bond. These distributions count as ordinary income. At one time, banks could include trups as capital reserves to meet regulatory requirements, but the 2010 The Dodd–Frank Wall Street Reform and Consumer Protection Act ended this practice.

Buying Trups

Trups trade on stock exchanges. They normally have fixed denominations of $25, which represents the principle amount that earns interest. The actual price you pay depends on supply and demand. You can buy them using your brokerage account. To research them, try one of the websites, such as QuantumOnline.com, that carry lists of trups and links to each one’s prospectus. (Ref 3) These sites, while free, normally require you to register. A site should be able to help you identify trups that yield more than do corporate bonds or preferred shares.

Calling All Trups

Issuers usually include a call feature in trups. This gives the issuer the right to redeem the shares for a set price on or after the call date, which usually occurs several years after the issue date. When the issuer calls trups, investors receive the call price and any accrued distributions. Issuers normally call trups when interest rates fall, because they can create new trups that pay out less, saving the issuer some money. Investors lose any price gains above the call price when the issuer calls the security.

Trups Risks

An issuer can defer some payments to trups, which lowers the return of investors. The bonds issued to trups are subordinated debt, meaning that if the issuer goes bankrupt and liquidates, other bonds that are more senior will repay first. Because of their relative obscurity, trups trade thinly and therefore with large bid/ask spreads. This illiquidity might make it hard for you to sell your shares. If interest rates rise, existing trups lose value because they will pay less than newly issued ones.

Pros and Cons

Preferred shares are equities with some bond-like characteristics. Therefore, it shouldn’t come as a surprise that its pros and cons reflect its hybrid structure.

Pros

  1. Dividend priority: Preferred share owners must receive their dividends before common stock holders do.      
  2. Liquidation priority: If a company liquidates, preferred share holders must repay before common stock holders are.
  3. Cumulative shares: If the preferred shares are cumulative, then the corporation must pay any missed dividends before paying common stock dividends.
  4. Options: Preferred shares can have a number of options to enhance their value, including convertible, putable, and exchangeable shares.
  5. D/E ratio: Issuing equity instead of debt reduces a corporation’s debt-to-equity ratio.

Cons

  • Voting: Preferred stock holders do not have the voting rights that common stock holders receive.
  • Cost of capital: It’s more expensive to issue preferred stock than it is to issue debt.      
  • Growth: Because preferred shares pay fixed dividends, they don’t participate in the growth of the issuing corporation.
  • Call option: Many convertible preferred shares are callable when the price of common shares appreciates. This limits the capital gains that preferred share holders receive.
  • Interest rates: Rising interest rates can make preferred shares dividends seem puny compared to bond interest rates.

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Frequently Asked Questions

Can compulsorily convertible preference shares redeem?

Corporations redeem compulsorily convertible preference shares for cash on their termination date or after their call date. Compulsorily convertible preference shares holders can convert to stock shares whenever profitable.

What is the difference between preference shares and equity shares?

Preference shares and common shares are both equity shares. Preference shares pay dividends before common stock does. Preferred shareholders have higher liquidation priority than do common share holders.

Why do companies issue preference shares?

They are more flexible than bonds because missing a dividend doesn’t cause the corporation to default. They also don’t provide shareholders with voting rights. Preferred shares don’t benefit from a corporation’s growth.

What is meant by redemption of preference shares?

Preference shares can redeem for cash by the issuing corporation. Usually, redemption delay until the first call date. When preference shares are putable, holders can force redemption on the put date.

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