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What are Preference Shares? From advantages to risks, all you need to know

Learn all about preference shares and explore their features, types, advantages, and risks to make informed investment decisions

Published: Jan 12, 2024 05:45:12 PM IST
Updated: Jan 18, 2024 04:49:17 PM IST

What are Preference Shares? From advantages to risks, all you need to know

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.

Features of preference shares

Here are some key features of preference shares:

  • Dividend preference: As the name suggests, preference shares hold a unique "preference" or priority over common shareholders. Preference shareholders have the first claim on the company's profits. They receive a fixed dividend before common shareholders receive any dividends.
  • No voting rights: Unlike common shareholders, preference shareholders typically don't have voting rights at shareholder meetings. They rely on the board of directors to make decisions on their behalf.
  • Priority in liquidation: In the event of a company's liquidation, preference shareholders are entitled to receive their capital back before common shareholders. This prioritisation of returns makes them "preferred shareholders” in this scenario.
  • Redeemable or irredeemable: Some preference stocks are redeemable, meaning the company can repurchase them at a predetermined price, while others are irredeemable; the company cannot buy them back.

Types 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:

Cumulative preferred share

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 preferred share

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 share

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 share

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.

Advantages of preference shares

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:

  • Steady income: Preference stocks offer a predictable income stream through fixed dividends, making them attractive for income-focused investors.
  • Prioritised returns: In cases of financial distress or liquidation, preference shareholders enjoy a priority in receiving their capital back, offering a level of security.
  • Portfolio diversification: Adding preference stocks to your investment portfolio can diversify risk and help you achieve a balanced investment strategy.
  • Convertible potential: Convertible preference stocks provide the opportunity for capital appreciation if the company's common shares perform well.

Risks associated with preference shares

While there are several advantages of preference shares, it's important to be aware of the associated risks:

  • Interest rate risk: The fixed dividends on preference stocks can become less attractive in a rising interest rate environment, as other investments may offer higher yields.
  • Lack of voting rights: Preference shareholders do not have a say in the company's decisions, which can be a disadvantage if the company's management makes unfavourable choices.
  • Market performance: The performance of preference stocks can be influenced by market conditions, and their value may fluctuate accordingly.
  • Call risk: If you hold redeemable preference stocks, there's a risk that the company may choose to redeem them, potentially leaving you with fewer investment opportunities.

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