Preferred Shares

On 07/28/2010, in Fixed Income, by Jordan Wilson

Today we will look at preferred shares.

Their characteristics and common variations that you will encounter in the investment world.

Although a type of equity, I shall write about preferred shares in the fixed income section. This is because the characteristics of preferreds make them more like debt than equity.

So what exactly is this hybrid asset that lies somewhere between debt and equity?

Ownership in the Company

Preferred stock is a means of ownership in a corporation. As part of a company’s ownership structure, preferred shares are part of shareholder equity on the balance sheet.

This differs from debt instruments which are merely loans to the issuer by the debt holder. As loans, debt is a liability of the issuer. Bond holders may have claims to specific assets upon default, but they are not owners of the issuing entity.

As preferred shares are equity in the company, there is no natural maturity date as with most debt. Although, as we will see below, a maturity feature may be added to the shares.

Preferred Status

As the name suggests, preferred shares have a priority to the company’s assets and earnings over common shares.

A higher claim on assets is important if the company breaks up, intentionally or not. If this occurs, preferred shareholders will be paid the par value of their shares before common shareholders.

The claim to earnings is crucial for dividend receipts. Dividends payments require adequate cash flow and earnings to ensure an uninterrupted stream to shareholders.

Dividends Not Capital Appreciation

Dividends are the main reason investors purchase straight preferred shares. Like bond coupons, preferred shares normally have a fixed dividend that is paid out quarterly (bonds usually pay semi-annually).

Preferred share dividends must be paid out prior to any dividend payments to common shareholders.

For “cumulative preferred shares”, any unpaid dividends accrue over time and must be paid in full before any other dividends are paid.

Also like bonds, the market value of preferred shares move in opposite directions to changes in interest rates. As general rates increase, preferreds with fixed rate dividends will fall in price. If rates decrease, the price of the shares will rise to reflect the lower yield in the marketplace.

Depending on the specific preferred share issue, there may or may not be any participation in the company’s performance. If not, these shares will react in price as if they were bonds.

No Voting Rights

Like bonds, preferred shares typically carry no voting rights within the company. Voting normally resides solely with common shareholders.

However, if dividend payments have been missed by the company for a period, often the preferred shareholders are granted voting rights on a contingent basis (usually while the dividends are in arrears).

While the above is generally true, like bonds, there are many permutations of preferred shares.

Also, companies may issue various classes of preferred shares with different features. These classes may rank equal in their rights or some classes may be subordinate in their claim to assets and earnings.

As was the case in our bond review, knowing the details for each issue is important.

Preferred Share Features

Preferred shares may incorporate many different features, creating different types of shares.

Most of these are almost identical to the bond variants we looked at previously. In fact, for the ones not listed below, you could look back at the bond features post for further preferred share possible combinations.

Straight Preferred

Pay a fixed dividend rate and trade in the open market on a yield basis as if they were a bond.

For example, XYZ company issues 5.5% Cumulative Series H Preferred Shares at $25 per share. If comparative interest rates increase, the share price will fall to provide investors with the market yield. If general interest rates decrease, the share price will rise to again reflect the market returns.

Variable Rate Preferred

Also called “floating preferred”.

These preferred shares are exactly the same as variable rate bonds. They pay a dividend that fluctuates with changes in interest rates.

For example, on January 1, 2010, ABC company issues Cumulative Series R Preferred Shares. These shares pay a fixed dividend of $2.00 per until December 31, 2011. Beginning January 1, 2012, the dividend rate will float at a rate of 70% the average US prime rate of interest.

Like the bonds of the same name, corporations normally include interest rates maximums and minimums to protect both themselves and shareholders from significant increases or decreases in interest rates.

Convertible Preferred

Like convertible bonds, the investor has the option to convert the preferred stock into some other class of shares at a fixed priced within a specified date or period. Normally the option is to convert the preferreds into the company’s common shares.

Because of the embedded option, a convertible preferred share will be priced somewhat higher than an equivalent straight preferred share. The premium paid by investors is the value of the embedded option.

The market value  of straight preferred shares fluctuates based on general interest rate levels relative to the dividend paid. Convertible preferreds though, are also affected by the market value of the shares that the preferreds may be converted into.

For example, each Convertco Cumulative Series B Preferred Shares are convertible into 1.2 common shares of Convertco. On July 5, Convertco common shares traded at $20.50 per share. At this price, the preferred shares would be worth $24.60 simply on the conversion factor alone ($20.50 * 1.2).

This would be the minimum value based on potential conversion. Because of the attached dividend, the preferred shares would actually be worth more.

As you pay a premium for the shares, you should believe in the underlying growth potential of the common shares. If not, then stick with straight preferreds and receive a higher yield on the dividend receipts.

Participating Preferred

Convertible preferreds provide the potential to capitalize on the growth of the issuing company. If the company grows and its common shares increase in value, you can convert your preferred shares to common shares (assuming that is the correct class) and benefit from the upside potential.

And, as we saw above, if the common shares have already increased in value, there will be a relative price increase to the preferreds as well, based on the conversion factor.

Participating preferreds also allow investors to benefit from the company’s success. In this case, it allows the preferred shareholders a right to a certain level of the company’s net earnings above the specified dividend rate.

This participation in the company’s net earnings comes in the form of a supplemental dividend, in addition to the normal payment. Often this is tied to the payment of dividends to common shareholders.

For example, Profitcorp has enjoyed a record year of earnings and cash flow. They are easily able to pay the dividends to holders of Profitcorp’s 10%, $25 Par Value, Cumulative Participating First Preferred Shares. With excess cash, Profitcorp decides to pay a $2.00 dividend to its common shareholders as well.

Under the terms of Profitcorp’s First Preferred Shares, any dividends paid to common shareholders must also be paid to holders of the First Preferred Shares at a rate of 50%.

In addition to the normal dividend of $2.50 (10% of 25 par value) received by the preferred shareholders during the year, they would also receive an incremental dividend of $1.00 (50% of $1 common share dividend).

As to the amount of extra dividends or the conditions for eligibility, one needs to review the relevant share documents.

Redeemable Preferred

Another one that we saw with bonds.

Here the company holds an embedded call option on the shares. This allows the company to redeem some or all of the shares within a specified period of time.

If the company redeems the shares on a gradual basis, they usually utilize a “sinking” or “purchase” fund to do so.

As the company holds the option, they must pay for their privilege. As a result, the company will pay investors a premium for this option.

For example, in 2000, Callco issued 8% Cumulative Redeemable Series F Preferred Shares with a par value of $25. The shares were redeemable by Callco at $28 until December 31, 2005, $26.50 until December 31, 2010, and at par thereafter.

As you can see, if you owned shares that were redeemed in 2004, you would receive a $3 premium on each share ($28-25). But with the passage of time, the premium falls to $1.50 from 2006 through 2010, and then is zero after 2010.

Many companies issue redeemable shares. In part, this is because preferred shares do not have a maturity date like bonds do.

If a company wants to retire its debt, it can simply wait to maturity and then repay the principal. Of course, companies can utilize callable or redeemable bonds as well.

Minus any features, preferred shares cannot be cancelled except through repurchases on the open market. This can be expensive and may not result in being able to purchase and retire as many shares as the company desires.

Retractable Preferred

These shares give the shareholder the option of selling the shares back to the company at a specified price within a specified period.

As the option to sell now lies with the shareholder, there is a premium paid by the shareholder for this right.

Typically, if the retractable preferreds are not converted within a maximum time frame, they convert back to straight preferred shares.

That should provide a sense of what preferred shares are.

It should also illustrate why many consider them to be more debt than equity.

Next up, considerations for investing in debt and preferred shares.

4 Responses to “Preferred Shares”

  1. Can’t find information like this all the time. Good stuff.

  2. I think this is a real great article post.Much thanks again. Really Great.

  3. I really liked your post. Great.

  4. Alison Alfer says:

    Can you comment on the process for a private company when a preferred shareholder files a Notice of Retraction for redemption of their preferred shares (in accordance with the rights attached to such shares)and the Company does not have the means to redeem?

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