Understanding what are Preferred Stocks and why are they beneficial: The dream security for many would be one that provides you both the inherent security found in bonds and returns of an equity stock at the same time. Luckily enough for us, such financial instruments exist and not only provide security but also steady returns in the form of dividends. This flexible security is known as a Preferred Stock or a Preference Share.
Today, we are going to discuss what are preferred bonds. Here, we’ll cover their meaning and also clear out what these bond and equity hybrids are in order to better understand and decide if they can actually be preferred over their parents
What are Preferred Stock/Preference Shares?
Many of us do not know that there are two types of stocks. The first being the common stock which we are accustomed to. The second being preference shares.
Preference Shares or Preferred Stocks offer investors preferential right over common stock when it comes to earnings and asset distribution. However, in exchange for these preferential rights, preference shares do not possess the voting rights in a company that the common stock holds.
What are the benefits of Preferred Stocks?
The investors benefit in the following ways when it comes to preference shares
1. Fixed Income
This means when dividends are announced, the payments will first have to be made to preference shareholders and only then to common shareholders. The dividend rates of preference shares are fixed at a predetermined rate or some other floating factor depending on the terms of the issue.
The decision on when dividends have to be paid is at the discretion of the board. This is because the Preference shareholders do not possess and voting rights in order to influence the board members or decisions.
2. Security in the case of winding up
Also in the case of winding up of a company, it is the preference shareholders who have priority in claiming the company assets. Only after the obligations to Preference shareholders are fulfilled will the obligations to common stock begin.
It is because of the above reasons that the Preference shares are known to be a hybrid. Just like bonds they offer regular returns with no voting rights. But like equity, the shares are allowed the trade and have the potential to appreciate in price.
Hierarchy of Bonds, Preference shares, and Equity shareholders
— In terms of Returns
It is the interest on bonds that are first serviced from the profits made by the company. Only then will the preference shareholders be paid the dividends due to them. In a case where the profits made are not sufficient then the preference shareholders and common shareholders can be left out. This is because unlike for bonds if the company does not pay preference shareholders it does not mean that the company is in default.
The bonds here are treated as debt whereas preference shares are not. In a scenario where there are sufficient returns first the interest on bonds is paid. Next, the preference shareholders are paid based on the rates set. Lastly, the remaining amount is paid to the equity shareholders. Only then is the remainder paid to the common shareholders. The dividends to preferential shareholders are preferred but not guaranteed.
Unlike bonds and preference share, there is no rate set to equity. This means that there is no upper limit nor lower limit to the dividends they receive. In exchange for preferential treatment, the preference shareholders will never receive dividends in excess of the rates prescribed to them.
Despite this common stock are greater wealth creators in comparison to preferred stock and bonds. This is because there is no limit on the increase in the stock price. When it comes to Preference shares the price generally looms around the face value.
— In terms of Claim over Assets
In the case of winding up, it is the bondholders who are first paid off followed by the preference shareholders and then the common stockholders.
— In terms of Risk
Preferred stocks are less riskier in comparison to equity. But when compared to bonds preference shareholders are considered to be riskier. This is because they fall back when it comes to being compared over the claim of assets and fixed interest rates that bonds have.
Equity shareholders are the riskiest here as they get leftovers of the bondholders and preference shareholders in the case of winding up. In a case, where the company is performing poorly, the share prices of common stock are also adversely affected.
Types of Preferred stock
There are various types of preferred stock. The following are the most commonly used
1. Cumulative Preference Shares
Say a company is in a bad shape and is forced to suspend dividends for the year. Here if the shares are Cumulative Preference shares, they are still entitled to receive the dividend for the year. Such a missed dividend payment will be added to the dividend payments of the following years and paid to the cumulative preference shareholders.
Eg. Company ABC has issued Cumulative Preference shares. ABC has issued 3000 10% cumulative preference shares at Rs.100 face value. Here the dividends payments ABC is obliged to make is Rs 30,000. But due to COVID-19, the ABC can only pay Rs. 10,000 of the dividend in 2020. Here the Rs. 20,000 is carried forward as arrears and paid the next year. Hence ABC will have to make a total dividend payment of Rs. 50,000 in 2021. Amount arising from Rs. 20,000 carried forward and Rs. 30,000 accruing in 2021.
2. Convertible Preference Shares
These preference shares can be exchanged for a predetermined number of common shares. Convertible Preference Shares can be converted only when the Board of Directors decides to convert them.
3. Callable preference Shares
Callable preference shares can be called back similar to bonds. In a call, the shares issued are bought back by the company by paying its holders the par value and at times a premium. This is done by the company in situations when the interest rates in the market fall. In such a situation the company realizes that it does not have to keep servicing the preference shares at the high rates it was issued a few years ago. The company simply calls back the shares and then reissues it at lower rates.
4. Perpetual Preferred Stock
Here there is no fixed date on which the investors will receive back the capital. Here shares are issued in perpetuity.
The types of preference shares mentioned above are common examples. The company, however, may combine one variant with the other and issue a preference share eg. Convertible Cumulative Preference Shares. If there are multiple issues of preference shares the shares may be ranked by priority.
In preference shares, the highest-ranking is called prior, followed by preference, 2nd preference, etc. The dividends and final settlements will be made in the order of this ranking.
Where are these Preference Shares available?
Preference shares are traded on the same exchanges like that of common stock. However, their issues are rare as companies do not generally go for preferred stock making their market small and their liquidity limited. The price of preference shares on these exchanges are determined by a variety of factors like dividend rate, the creditworthiness of a company, type of preference share eg, cumulative, convertible, etc.
The share prices of Preference shares like bonds have an inverse relationship with interest rates.
What to look before buying Preference Stocks?
Apart from looking at the type of preference share and the interest offered, it is also important necessary to figure out why the company issuing Preference Shares?
It is a known fact that companies issue preference shares in order to avoid dilution of capital. But it is also noticed that companies issue preference shares when they have trouble accessing other means of capital. This may be because banks are refusing loans due to their low creditworthiness. Raising money through Preference Shares is cheaper as it gives the option to the company to only serve them when they are able to, unlike other debt instruments.
Another reason may also be that preference shares do not reduce the creditworthiness of a company, unlike debt that is added to the balance sheet. The company can issue preference shares that act like debt but are shown as equities in the balance sheet. Happy Investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.