Preferred Shares: An Introduction

Whenever the topic of fixed income securities is considered, the obvious assumption many investors make is that the conversation is about bonds. It is true that bonds are the most commonly traded types of fixed-income securities. However, they are not the only type of fixed-income securities. Preferred shares are another common type of fixed income security that is used widely by investors all over the world. In this article, we will have a closer look at how preferred shares work.

What are Preferred Shares?

Preferred shares are considered to be hybrid securities. This means that they have the characteristics of both debts as well as equity investments. On the balance sheet of a company, they are officially classified as equity. There are some characteristic issues of preferred shares which have been mentioned in the article below:

• Preferred shares share some characteristics with bonds. This means that they also have a fixed interest rate. This interest rate could be completely fixed or it could be a floating rate. Also, just like bonds, these securities also provide periodic payments, which could be disbursed quarterly, semi-annually, or annually. It is important to note that these periodic payments are called preferred dividends and not coupon payments.

• However, preferred securities are different compared to bonds in the sense that the company makes a commitment to pay the dividend only on a best-effort basis. This means that the company is obligated to pay the preferred dividends if there is a profit or positive cash flow. However, like debt, there is no obligation to make payments in the absence of a profit. Also, if a company fails to make a periodic payment, it would not trigger a default like debt securities.

• Preferred shares do not have any set maturity like bonds do. This means that the company has no real obligation to pay back the money received from preferred shares. However, these bonds tend to be callable. This means that companies have the option to call the preferred shares and pay back the initial funds taken if they are able to obtain funds at a lower cost. Generally, the company has an option to call preferred shares every five years.

• Preferred securities are junior to senior secured debt in the capital structure of the firm. They may be ranked higher than certain forms of unsecured debt. However, generally preferred securities are ranked in between debt and equity. This means that in the event of a default, preferred shareholders will get paid after bonds and before shareholders.

• Preferred shares issued by blue-chip companies are considered to be of investment grade. This means that institutional investors and pension funds all over the world are generally allowed to hold these bonds. This is important since it creates increased demand which eventually leads to increased liquidity.

• Another very important distinction between preferred shares and regular shares is the fact that regular shares have full voting rights in the firms’ affairs. On the other hand, preferred shares have no voting rights. This is important for many companies since issuing voting rights to preferred shares would mean diluting the control of the firm.

• Preferred shares are just like shares as well as bonds in the sense that they can be traded freely over an exchange. Hence, investors do not have to wait for the company to repay their principal. They can find a buyer in the secondary market and can exit the investment whenever they feel like it. There are some classes of preferred shares which may not be traded on the exchange. However, these are generally held by corporate investors and can be easily liquidated using over-the-counter markets.

Why Do Companies Issue Preferred Shares?

Preferred shares are issued by a lot of companies across the world. This is because these shares provide certain distinct benefits.

Firstly, preferred shares are used by promoters to pay themselves compensation.

• This is because preferred shares can be paid out regularly and also because preferred shares are a more tax-efficient way of withdrawing money from a company. The income from preferred shares is taxed at a lower rate in many countries as compared to other income received by the same people

• Regulatory norms such as Basel III consider preferred shares to be a part of Tier-1 capital. This is because there is no immediate obligation to pay these shares. As a result, they help organizations meet regulatory norms. This is why they are issued by companies even though they have to pay a slightly higher interest rate as compared to bonds. These shares help companies raise capital while not reducing their borrowing capacity or skewing their debt-to-equity ratio.

Classes of Preferred Shares

Lastly, it is important to realize that not all classes of preferred shares are the same. It is common for companies to issue two or three different classes of preferred shares wherein each of these shares has different features and receives different compensation in return. The higher class of preferred shares may have more debt-like features which make them rank higher in seniority whereas the lower classes may have more equity-like features.

The bottom line is that preferred shares are a very important segment within the fixed-income securities market. It is important for investors to be cognizant of the various kinds of opportunities that they can take advantage of if they want to trade in preferred shares.

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