WITH increased volatility in financial markets and record low yields on fixed-income securities, investors have begun to re-examine their risk appetite.

For the boom years prior to the near financial market collapse in 2008, investors were prepared to look outside of what was traditionally consistent with their risk appetite and ventured into new realms of higher risks. Pensioners were buying derivatives they did not understand, and young professionals were caught up in get-rich-quick schemes. This resulted in a sizable loss of wealth for many investors.

At the onset of the financial crisis, ordinary share prices in the US plummeted. Stock indices have subsequently recovered on account of the expansionary monetary policy of the US Federal Reserve and the signs of improvement in the US economy. However, the imminent rise in the Fed’s benchmark interest rates will fuel volatility in stock and bond prices — the direction of which is uncertain.

One possible option for investors to consider is preference or preferred shares.

Preference shares or “preferreds”, as they are commonly called, are a hybrid security with characteristics of both ordinary shares and a bond. Preferreds do not carry voting rights, but they have a higher rank than ordinary shares in the distribution of cash. This preferred ranking applies to dividend distributions or proceeds from the liquidation of assets.

However, the amount of the cash distributed to preference shareholders is usually pre-established in the terms and conditions governing the security. Additionally, preference shares can attract a fixed or floating coupon that pays on a regular basis. In this way, preferred shares are similar to bonds. Preferreds may also have other features such as call options — meaning the issuer may decide to redeem the shares prior to maturity. In addition, preferreds may be listed on a stock exchange to allow the holder to trade the shares like a normal stock.

There are various types of preferreds (prefs) and there is a wide array of different terms and conditions that can apply to them. Among the more popular types are cumulative, convertible, participating and perpetual.

Cumulative prefs do not require the issuer to pay out a regular cash dividend. Cumulative preferred shares accumulate dividends at a pre-defined rate of return and the issuer must pay the accumulated amount within the tenor of the shares. This allows the issuer to defer dividend payments in the event the company’s current cashflow is not able to support a payment at the time it becomes due.

Other types of preference shares include participating preferreds, which allow the holder of the shares to participate in cash distributions above the pre-established coupon payments. This could be in the form of a set percentage of net profits or a sum above a particular predetermined hurdle rate.

Another popular type of pref is the convertible preferred share. This preference share enables the issuer to convert the prefs to common equity at their discretion.

In some markets, a unique type of preferred share exists called a retractable preferred share. This instrument allows the holder of the shares to sell the share back to the issuer either for cash or for common shares.

The accounting treatment of preferreds in a company’s capital structure is also relevant to investors. Preferred shares are usually reflected in the company’s shareholder equity and do not share the same ranking as debt. This allows some companies to meet target debt/equity ratios.

Given the wide variety of preference shares available, investors can choose the features that mean the most to them. Depending on the type of preference share you own, your ability to participate in the upswing in the performance of the company may be limited.

While preference shares can rise in price (and give investors the opportunity to enjoy capital gains), the price movements may not be as large as those generated by ordinary shares. However, this can also act as protection for investors who are concerned about downside price risk. Additionally, yields on preferreds can compete favourably with the yields on corporate bonds.

Preference shares could be a good option for any portfolio.

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