Preference shares are a type of stock that typically pay fixed dividends, which are disbursed before any dividends to common shareholders. This predictable income can make them appealing to fixed-income investors but before adding them the fixed income investor should consider the pros and cons of holding them in their portfolio.

There are many positives for holding preference shares. These include:

1) You will typically receive scheduled dividend payments at a predetermined rate. This rate is normally much higher than dividends declared for common shareholders.

2) In a worst-case scenario if an issuer goes bankrupt, preference shareholders are higher in the line of repayment than those who hold common stock. You must be repaid in full before a common stockholder. By investing in preference shares you give your portfolio diversification but take on less risk than that of common stock.

3) Many preference shares also have a cumulative feature which means that if a dividend is missed they accumulate and are paid out at a later date.

Like any other fixed income investment there are also risks to investing in preference shares. Some of these are as follows:

Interest rates risks

An increase in interest rates could negatively or positively impact the value of preferred shares. For example, a fixed rate dividend may no longer seem as attractive when interest rates rise as the fixed dividend will compare poorly to new issues in the current environment. An issuer may also choose not to redeem those preference shares as a new issue would cost them more and it is beneficial to them to pay a lower interest rate. This will clearly impact the investor who was waiting on their principal to be repaid.

Credit risk

Investors should ensure that the issuer of the preference shares has a high capital adequacy which refers to the firm’s ability to absorb potential losses while continuing operations. Preference shareholders are close to the bottom of the capital structure and near last in receiving any cash back in a liquidation procedure. If the issuer of a preference share receives major ratings downgrades this could mean that the trading price of their common stock and preference shares may decline. This deterioration would make the shares less attractive and ultimately less liquid.

Extension risk

A commonly overlooked feature of preference shares is extension risk. While investors can sell their preferred shares on an exchange, an issuer may have the right to defer redemption, leaving investors holding the shares longer than anticipated. An investor who was expecting to exit at a specific time may now have to wait for a future redemption opportunity or sell on the open market. If the investor opts for the latter, they will ultimately be selling at the market price and may be exposed to price risk on their principal, as the current trading price could be lower than the initial investment.

Liquidity risk

Preference shares are traded on an exchange, but they typically have lower trading volume than common stock of the same issuers. As a result, investors should be aware that in an emergency or if a better opportunity arises, they may not be able to sell their shares and recover their principal as quickly as desired. The ability to sell depends on market demand and available buyers.

To decide if preference shares are right for your investment portfolio, speak with a reputable licensed financial advisor.

Christine Rankine is Assistant Vice-President -Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

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