Investing in Preferred Stocks / Preference Shares: What, How and Why

Preferred stock preference share zaginvestor

Investing in common stocks is well understood, but what about preference shares? In this article, we examine in detail about the various types of preference shares and highlight what you should look consider before investing in them.

Before we start, it’s worth highlighting that the following are used interchangeably throughout the article:

  • Preference shares, preference stocks, preferred shares and preferred stocks.
  • Common equity, common stocks, ordinary shares and ordinary stocks.
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    What are preference shares?

    Preference shares, more commonly known as preferred stocks, are shares that pay pre-defined dividends. In addition, they function as hybrid securities, armed with equity and bond-like characteristics. For this reason, preference shares are considered less risky relatively to common shares.

    Features of preferred stocks

    Fixed dividends

    Unlike ordinary stocks, where dividends are optional, preferred stocks have fixed pre-agreed dividend throughout its tenure. Provided there are no material cash flow constraints, owners should expect a fixed-dividend, usually paid twice per year.

    For example, assume that company ZAG pays out 100% of its annual earnings to its preferred stocks and common stocks holders. For simplicity, our base case is ZAG earns $100 per year. In addition, the preferred stock owners have a fixed dividend of $30 per year.

    The setup’s done! Let’s consider these two scenarios

    • Scenario A: Company earns $100 (base case)
    • Scenario B: Company earns $45, due to _____ (fill in the blanks)

    Here’s how the payout structure would look under both scenarios.

    Scenario Preferred stock holders Common stocks holders
    A (base case) $30 $70
    B $30 $15

    In both scenario, preferred stock holders are entitled $30 despite varied company earnings. Its consistent delivery of dividends can be attractive to investors seeking a stable and passive income stream.

    Voting rights

    One of the key differences between preferred stocks and common stocks owners is its voting rights. Generally, preferred stocks has no voting rights. There are exceptions, however. We explain in more details in the “cumulative/non-cumulative" section.

    Seniority / Ranking

    Preferred stocks take precedence over common stocks in terms of dividends. This means that the company must first pay preferred stock holders before common stock holders. Hence, the name “preference” or “preferred”.

    In particular, this is especially important during a bankruptcy, where holders of preferred stock are rank ahead of common stock owners in capital recovery. The concept is analogous to our example in the beginning of the article.

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    Types of preferred stocks

    Cumulative / Non-cumulative

    Preference shares can be classed as either cumulative or non-cumulative. Cumulative preferred stocks gives owners a right to receive dividends that were missed in previous years. Conversely, issuing companies are not obliged to repay what have been missed if it's non-cumulative.

    Cumulative preferred stocks holders are only entitled voting rights if the dividend payable are missed and due in arrears. On the other hand, this is not applicable for non-cumulative holders as companies are not obliged the repay what has been missed.

    Assume company INV has both cumulative and non-cumulative preferred stock holders. They each have a fixed dividend of $30 and $40, respectively.

    We consider different scenarios over a three-year period

    • Year 1: Both holders are paid in full.
    • Year 2: INV made a big loss and is unable to pay to any holders.
    • Year 3: Profitability rise and INV is able to pay out in full again.
    Cumulative Non-cumulative
    Year 1 $30 $40
    Year 2 $0 $0
    Year 3 $30 + $30 = $60 $40
    Total received $90 $80

    The key difference between both is highlighted in red in Year 3. From the table, total received in Year 3 for cumulative preferred stock holders includes Year 2's missed payment. Importantly, cumulative holders have priority over its non-cumulative counterpart.

    Consequently, non-cumulative preference shares are deemed more risky because of the companies’ non-obligation to repay previously missed payments. For this reason, non-cumulative generally offers higher fixed dividend to compensate such risk.

    Redeemable preferred stocks

    Redeemable preferred stocks are preference shares that allow the issuer to buy it back at a pre-agreed price after a specific date. The key terms of redeemability are

    • A fixed time/date of an event happening
    • At the company’s discretion (this is also known as Callable Preference Shares)
    • At the shareholder’s discretion

    Preferred stocks that are issued without maturity date (or any redeemability features) are known as perpetual preferred stocks. As a result, owners of these securities have the right to receive fixed dividend indefinitely, as long as the issuer remains capable to do so.

    For investors, redeemable preferred stocks can be a double-edged sword. It provides the flexibility to redeem depending on market conditions but also introduces uncertainty if they’re redeemable at the companies’ discretion.

    Irredeemable preference shares and perpetual preferred stocks are used interchangeably, although definition varies depending on country. Unfortunately, it’s still legally possible for a company to “redeem” its “irredeemable” preference shares, as Aviva, a UK-based insurer, has argued their case in 2018.

    Partcipating preferred stocks

    These are preference shares with a potential for additional dividends that are based on certain pre-defined condition. A go-to funding choice for private equity and venture capital firms, the earn-out structure is attractive because it aligns stakeholders' incentives.

    For investors, investing in these shares provide the opportunity to participate to surplus company profits. On the other hand, this comes at a cost of a lower fixed dividend relatively to vanilla preferred stocks.

    Convertible preferred stocks

    Convertible preferred stocks are preference shares that provide an option to convert their preferred stocks into a fixed amount of common stocks at a certain point in time.

    Hope you don't mind a bit (just three) of financial jargons before we move on!

    Conversion ratio

    This is the number of common shares received per preferred stock upon conversion, pre-determined at inception.

    Conversion price

    This is the price for converting preferred stock into common stock. In layman’s term, this is the minimum price of its common stock for the conversion to be profitable. Loosely known as the “cost” of conversion.

    Conversion price = Price of preferred stock / Conversion ratio

    Conversion premium

    This is the difference between the current market price of convertible preference shares and the conversion price. In this case, this is frequently expressed in percentages.

    Conversion premium = (Current market price of convertible – Conversion price) / 100

    When should you consider converting?

    The optimal region of converting is when conversion premium is positive. In other words, when the conversion price is greater than the common stock price.

    Assume you own a convertible preferred stock of company EST that costs $100 per share, and pays a fixed-dividend of $5 per share, with a conversion ratio of 2.

    Consequently, the conversion price is $50 ($100/2). If the common stock is trading above $50, say $X, you can make a profit of $(X-50) per share. Likewise, if the common stock is trading at $50 or below, there is no immediate monetary benefit if converted.

    Obviously, converting means giving up the rights as a preferred shareholder and becoming a common shareholder. In addition, you lose the “fixed-dividend” nature of preferred stocks, but gain voting rights and the opportunity to participate in the upside of ordinary shares.

    Similar to participating preferred stocks, the option to convert to ordinary shares when favourable comes with a cost. Namely, lower fixed dividend relatively to typical preferred stocks.

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    Advantages and disadvantages of preferred stocks

    Advantages of preferred stock Disadvantages of preferred stock
    Stable income stream No voting rights
    Less risky relative to common equity Exposed to the uncertainty of redemption from issuer
    Rank ahead of common equity in capital distribution Limited appreciation potential
    Similar to bonds, capital value may decrease as interest rates rise

    Bonds vs Preferred stocks vs Common stocks

    Seniority / Ranking Ahead of preferred stocks Ahead of common stocks Lowest
    Payment structure Fixed and variable Fixed Variable
    Terms of payment Obligation Right to receive, but not an obligation Optional
    Yield Lower than preferred stocks Often higher than common stocks Depends on company profitability
    Capital appreciation Limited Limted Unlimited
    Voting rights No Usually no Yes

    Why do companies issue preference shares instead of debt/common equity?

    The financial services sector is one of the largest issuer of preference shares globally. Consequently, in a heavily regulated sector, preference shares are deemed capital friendly, hence its attractiveness. In addition, it also provides a cheaper funding alternative to common equity.

    Companies may also issue preference shares instead of debt to preserve its debt-to-equity ratio. Furthermore, the consequences of failing to make an interest repayment is far more serious than failing to make a dividend payment to preferred stock owners. In short, companies may issue preference shares to provide operating flexibility and to optimise its capital structure.

    What to look for when investing in preference shares?

    Firstly, because preference shares pays fixed dividend, company fundamentals are paramount. Debt-to-equity ratio, dividend policy and free cash flows should be priority when considering what preferred stocks to invest in.

    Secondly, be aware of the features attached to the shares, especially its redeemability and whether it’s cumulative. Aviva attempted to “redeem” a class of preference shares that was previously thought to be “irredeemable”, causing close to ~30% fall in its preference share price.

    Lastly, valuation. Don’t get carried away by the fixed dividend stated on its security name. Instead, focus on the valuation - the current net yield. This is the yield that you’re getting if bought today. Check the tables in the next section.

    How to invest in preference shares?

    There are two main ways to gain exposure into preference shares. First, directly purchasing preference shares. Here is a list of selected UK preference shares.

    (Prices are as of 6 May 2020)

    BP PLC 8% PRF #1 8.000% 5.1% 63.7%
    BP PLC 9% 2ND PRF #1 9.000% 5.1% 56.7%
    RSA INSURANCE GROUP PLC 7 3/8% PRF #1 7.375% 6.4% 86.2%
    LLOYDS BANKING GROUP PLC 6.475% PRF 6.475% 6.3% 97.3%
    LLOYDS BANKING GROUP PLC 9.25% PRF 9.250% 7.1% 76.9%
    LLOYDS BANKING GROUP PLC 9.75% PRF 9.750% 7.2% 74.2%
    AVIVA PLC 8 3/8% PRF #1 8.375% 6.5% 78.1%
    AVIVA PLC 8 3/4% PRF #1 8.750% 6.4% 73.0%
    GENERAL ACCIDENT PLC 8 7/8% PRF #1 8.875% 6.6% 74.9%
    GENERAL ACCIDENT PLC 7 7/8% PRF #1 7.875% 6.7% 85.1%
    STANDARD CHARTERED PLC 8 1/4% PRF 8.250% 7.0% 85.1%
    STANDARD CHARTERED PLC 7 3/8% PRF #1 7.375% 6.5% 88.7%

    Some preference shares are notoriously illiquid, hence, trade at a large bid-offer spread. For this reason, we encourage new investors to seek large cap / blue chip issuers that are traded in main exchanges.

    Alternatively, we can also gain exposure via Preferred Stock ETFs. We highlight the largest ETFs in this space.

    (Prices are as of 6 May 2020)

    Investing in preferred stocks requires the appreciation of its features and terms attached to it. If done well, preferred stocks can play a significant role in generating a stable and passive income stream for investors.

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