Preference shares - a viable fixed income alternative?

The Sterling Report

With Marian Ross

Sunday, September 05, 2010

What are preference shares?

Preference shares are a form of equity which represent a senior tier of ownership in a company. The structure of preference shares is usually determined by the issuing entities. They are always senior to common shares but subordinate to the debt of the company. Preference shareholders must receive dividends as well as any proceeds of asset liquidation prior to their distribution among common shareholders. It helps to think of preferred stocks as a hybrid security that shares characteristics with both common stock and bonds.

How preference shares work

Preference shares have a number of common characteristics with bonds. For example, preference shares are generally issued at a par value and pay dividends at a fixed rate based on a percentage of that value. When interest rates rise, the price of the shares fall and vice versa. Despite their sensitivity to interest rates, preference shares generally exhibit far less interest rate volatility than bonds.

Preferred shares generally attract dividends at a fixed rate. However, the recent introduction of adjustable rate preference shares permits dividends to vary according to terms and conditions specified by the company. Usually, the dividend is tied to a selected benchmark interest rate. In both cases, dividends are paid from after-tax profits and at the discretion of the Board of Directors. As such, preferred stocks do not guarantee investors a consistent stream of income. With respect to the payment of dividends, preference shares can either be cumulative or non-cumulative. Cumulative preference shares are structured such that if the company does not pay all or part of the stipulated dividend, it must settle all dividends in arrears prior to any subsequent dividend distributions. In contrast, non cumulative preference shares do not compensate holders for unpaid or withheld dividend distributions. A company may choose to withhold dividends in order to reinvest a larger proportion of earnings into the business or as a result of cash flow difficulties.

Preference shares are frequently structured with a "call option" i.e. the option for the issuer to re-purchase the security. The price and date can be established at the point of issuance or may be flexible and determined by the issuer.

Preference shares can also be designed with a feature to facilitate their conversion into common shares. This can take the form of an option that may be exercised by the investor at any time or at a pre-determined date and price at which the preference shares can be converted. This feature allows investors to secure their dividends for a given period of time and to take advantage of the opportunity for the subsequent capital appreciation that is inherent in common stocks. It is important to note that unlike common equity, preference shares usually do not carry voting rights.

Preference share investment strategies

Preferred shares provide a more attractive rate of return than bonds (due to the higher risk inherent in the security) and a stream of income that is more secure than common equity dividends . Preferred stocks are a worthwhile addition to any medium to long term investment portfolio.

Standard & Poor's (S&P) research purports that preference share returns exhibit relatively low correlation with common stock returns, bonds and expected volatility . In other words, the returns on preference shares do not fluctuate as drastically in response to external events. The magnitude of the changes in the price and yield on preference shares is much smaller. As such, preferred shares complement bond portfolios and are good tools for stock portfolio diversification.

How can preference shares create value for your business

Preference share issuance is a viable avenue for companies seeking to raise additional capital. It is worth noting convertible preference shares are used extensively in the U.S. venture capital market as a means of external financing for early stage venture capital companies .

Preference shares can also be issued to diversify a company's capital structure. Preference shares can be designed to increase cash flow and retained earnings or even lower a company's weighted average cost of capital.

Preference shares can create value for business owners and investors. Investors should consider them as a means to achieving their investment objectives.

Marian Ross is a business development officer with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net

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Preference shares - a viable fixed income alternative?