Learn all about preference shares and explore their features, types, advantages, and risks to make informed investment decisions
Preference shares, also known as preferred stock, are a type of security issued by a company to raise capital. They represent ownership in the company but come with distinct features that differentiate them from ordinary shares.
These shares combine equity and debt features, offering investors a fixed dividend, priority in dividend payments over common shareholders, and, in some cases, the option to convert them into common shares.
The key attraction of preference stocks lies in their promise of stable income, making them a favoured choice for income-oriented investors. They also play a crucial role in a company's capital structure, providing a source of funds that doesn't dilute the voting power of common shareholders.
In recent years, with the sustained bear market prevailing worldwide, an increasing number of investors are considering preference shares as a viable avenue to achieve substantial long-term returns.
Before investing in preference shares, it is essential to consider your investment goals, risk tolerance, and the specific terms of the shares you're interested in, and consult with a financial advisor if needed.
Let’s look at the features of preference stocks.
Here are some key features of preference shares:
Now that we have learned the features of preference shares let's look at the types of preference stocks. Different preference shares are tailored to meet diverse investment preferences and risk profiles. Here are some common types of preference shares:
With cumulative preference stocks, if a company fails to pay the promised dividends in a particular period, the unpaid dividends accumulate and must be settled in the future before any dividends are distributed to common shareholders or other equity holders.
This means that even if the company experiences a temporary financial setback and cannot pay dividends to preferred shareholders, it accumulates as a debt owed to them, and the company must eventually catch up on these payments when it is financially able.
This feature provides stability and assurance to investors prioritising a consistent income stream, reducing the risk of missing out on dividends during challenging financial periods.
Non-cumulative preference stocks do not allow for the accumulation of unpaid dividends.
In other words, if the issuing company fails to pay dividends to its non-cumulative preferred shareholders in a particular period, the unpaid dividends are forfeited and do not accumulate or carry over to future periods.
Non-cumulative preferred shareholders receive their fixed dividends only when the company declares and pays them for a specific period. Any missed payments do not create an obligation for the company to pay them back in the future.
This makes non-cumulative preferred stock riskier regarding dividend reliability than cumulative preferred stock, which accumulates unpaid dividends and requires them to be paid to shareholders.
Participating preferred stock allows its holders to receive additional dividends beyond the fixed rate specified in the stock's terms. These additional dividends are typically contingent on the company's financial performance.
In other words, if the company's profits exceed a certain threshold, participating preferred shareholders have the right to participate in those excess earnings, sharing in the company's prosperity alongside common shareholders. This feature makes participating preferred stock more appealing to investors looking for the potential of higher returns when the company performs well.
Convertible preferred stock can be changed into common shares of the issuing company based on predefined conditions and terms. This means that holders of convertible preferred stock can exchange their preferred shares for common shares at a specified conversion ratio.
The primary advantage of convertible preferred stock is the potential for capital appreciation. If the company's stock price increases significantly, converting preferred shares into common shares can result in higher returns for the investor. This feature makes convertible preferred stock an appealing choice for those seeking a blend of fixed income and the potential for participation in the company's growth.
However, it's important to note that the conversion is typically subject to certain conditions, such as a specified conversion price or period. Investors should carefully evaluate these terms and the company's performance before converting their preferred shares. Convertible preferred stock is a versatile financial instrument that offers income stability and the opportunity for capital gains, making it a valuable addition to an investment portfolio.
Now that you're acquainted with the types of preference shares, let's explore why you should consider them an investment option. Here are some advantages of preference shares:
While there are several advantages of preference shares, it's important to be aware of the associated risks: