WITH increased volatility in financial markets, particularly over the last five years, people have begun to take greater stock of what their risk appetite is. For the boom years prior to the near financial market collapse in the US, people were prepared to look outside of what is traditionally consistent with their risk appetite and had ventured into new realms.

Pensioners were buying derivatives they didn’t understand and young professionals were caught up in get-rich-quick schemes resulting in huge financial losses and the loss of wealth for many. Ordinary share prices over that period plummeted to new lows, but have now recovered because of persistent Fed easing.

However, the likelihood of the Fed raising rates in the near term could send stock and bond prices back in a tailspin. One possible option for investors to consider would be preferred shares or preference shares.

Preference shares or preferreds, as they are commonly termed, are a hybrid security with characteristics of both ordinary shares and a corporate bond. They do not carry voting rights as do ordinary shares, and most preferred shareholders are never present at stockholder meetings or AGMs.

They have a higher rank than ordinary shares in the distribution of cash, whether as regular dividends or from liquidation of assets. However, such distribution is usually limited by the terms of the preference shares, such as a fixed coupon. Preferreds may have other features such as being callable, that is the issuer, at its discretion, may decide to redeem the shares prior to maturity.

In addition, preferreds may be listed on an exchange to allow the holder the ability to acquire or dispose of shares as long as there is a willing seller and a willing buyer.

There are various types of preferreds, the more popular ones being: cumulative, convertible, participating and perpetual. Cumulative prefs allow the issuer to accumulate dividend payments in the event the company’s cashflow is not able to handle a payment.

All dividends that are due would be accumulated and when cashflow improves a lump sum payment would be made. Other types include participating preferreds, which allow the holder of the shares to participate in further cash distribution above and beyond the coupon payments. This could be in the form of a set percentage of net profits or a sum above a particular predetermined hurdle rate.

The type of preferred stock that most closely mirrors common equity would be a perpetual preferred or a “perp” where there is no set maturity date. Like a common stock, it will pay cash distribution to perpetuity or until the company is wound up.

One of the more popular types of preferreds is the convertible, which, as we mentioned earlier, allows the issuer, at their discretion, to convert the preferreds to common equity or through the occurrence of a target event. In some markets, a unique type of preferreds called a retractable preferred exists, which allows the holder of the shares to put the share back to the issuer to be redeemed either for cash or for common shares.

The accounting treatment of preferreds is also a very simple one. Preferred shares are usually reflected in the company’s shareholder equity and not as debt, because although there may be fixed coupon payments, such payments are not guaranteed and sometimes are accumulated. This could allow some companies to meet target debt : equity ratios to meet specific regulatory requirements.

Some of the negatives of preferred shares include the inability to participate in the upswing in the performance of the company. Common shareholders would benefit from capital appreciation if the demand for the company’s stock rises because the company’s performance outpaces expectations.

This benefit could also extend to higher cash distribution in addition to regular dividends, while preferred holders and bond holders only receive a fixed coupon payment, no matter how well or how poorly the company performs.

Liquidity can also be another drawback for investing in preferred stock, as opposed to common shares or even a bond. Often, preferreds are held by a smaller group of individuals and the level of trading in these shares tends to be

less than trades in

common shares.

On the positive side, there could be more favourable tax treatment for preferreds, over holding a bond whereby interest is taxed at a higher rate than the rate paid on dividends. Additionally, yields on preferreds could compete favourably with the yields on corporate bonds, which also makes them a good option for any portfolio.

Expect to see more preferreds being issued as companies find more creative ways of raising funding outside of traditional common equity and debt.

Kevin Richards is vice-president, sales and marketing at Sterling Asset Management Ltd. Sterling is a licensed securities dealer and provides investment management and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm