Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.
Most ordinary investors haven't heard of preference shares. Or if they have it's only because of the legendary Warren Buffett's investment in the preference shares of Heinz (of 57 varieties fame).
There are many different kinds of share, other than the ordinary shares we naturally think of, and one of the most interesting to investors are preference shares.
Preference shares (also known as preferred stock or 'prefs' for short) can give offer very high yields to investors. Is this worth it, given the risks involved? And what are you trading off in return for these high yields?
How Preference Shares Work
Preference shares are shares in the company but they are different to ordinary "common stock" shares.
Ordinary share dividends are not set in advance, but preference share dividends are fixed and are always paid before any ordinary share dividends can be paid.
Generally, preference shares do not get a vote in the company like ordinary shares do. The exception is if the preference shares dividend is not paid.
Preference shares can be "cumulative" or "non-cumulative". A cumulative preference share will have any missed dividends made up the next time around before any ordinary dividends. A non-cumulative preference share will not and every dividend is treated separately. There is no "making up" of any past underpayment.
Sometimes preference shares are "callable"—this means that the issuing company can redeem them for a fixed pre-agreed price. And that is their choice not yours.
These features (fixed dividend, redeemed for fixed amount, better security than ordinary shares) mean that preference shares are, in some ways, more like corporate bonds from the point of view of an investor.
What Preference Shares are Like as Investments
Because Preference Shares are a bit of a hybrid between ordinary shares and corporate bonds their investment characteristics are in some ways like ordinary shares and and in other ways like corporate bonds.
Like ordinary shares, preference shareholders only get paid once all creditors (like employees owed wages, bond holders owed coupon payments and banks owed overdrafts) have been paid.
However like bondholders, preference shareholders get paid before ordinary shareholders. So the credit risk is higher than on a corporate bond from the same company but less than the credit risk on that company's ordinary equity stock.
The dividends are fixed—which is similar to a corporate bond. But (especially for non-cumulative preference shares) non-payment of dividends is not like defaulting on a corporate bond—there may still be future payments if the company returns to profit. But defaulting on a corporate bond may cause the company to be restructured or broken up.
Understanding the risks that preference shares have as an investment can let you understand the individual components of the return you are getting for them—because the different "risk premium" can be thought of as compensation for taking on those kinds of risk.
Spreading Your Risk by Buying Different Investment Classes
When investing it's important to spread your risk and tailor your portfolio to your needs by diversifying into different kinds of investments.
Diversification is basically a fancy way of saying "don't put all your eggs in one basket". Having investments in different companies and in different asset classes can make sure you are less likely to lose it all. But it's not magic and doesn't mean you shouldn't do your own research.
Adding a rarer asset class like Preference shares can really help.
3 Advantages of Investing in Preference Shares
Preference shares come with certain advantages. Below are three of the main benefits you can expect from preference shares.
1. They Have Higher Yields Than Corporate Bonds From the Same Company
But remember this higher yield has to pay a higher yield to compensate for the higher risk that the company will default and you won't get your money. Remember bondholders and other creditors will come higher in the payout order than you. Higher return is usually a trade-off for higher risk—which is OK as long as you understand the risks you are taking.
2. They (Usually) Have Higher Income Than Ordinary Shares in the Same Company
Because preference shares don't benefit from growth in dividends and capital value more of the return has to be paid out in dividends from the beginning. That makes preference shares a better option than ordinary shares for investors who plan to take the income, for example to live in on retirement. (See here for the difference between capital gains and income—the two ways you get a return on your investments.)
It is possible that over time if the ordinary shares have very high dividend growth they will end up paying a higher dividend than the preference shares but that is not guaranteed and make take a very long time, in any case.
3. They Are More Secure Than Ordinary Shares
Although you rank behind bondholders and other creditors in the payout order, preference share dividends have to be paid before ordinary dividends can be paid—so you are ahead of ordinary shareholders.
4 Disadvantages of Investing in Preference Shares
Like any other investment, preference shares can be a double-edged sword. Below are four potential pitfalls of preference shares.
1. They Have Higher Risk Than the Same Company's Corporate Bonds
The trade-off for a higher yield than on the company's bonds is that the bondholders will get paid first if the company runs out of money.
2. They Have Lower Expected Returns Than Ordinary Shares
Because ordinary shares get the benefit of future growth in dividends and capital value, on average ordinary shares will make more money in long run. However this isn't guaranteed, ordinary shares may also make less than the preference shares.
3. They May Be Harder to Buy and Sell
There is a smaller market for preference shares generally, which means that is can be difficult to sell a lot of them in a hurry, without taking a lower price. However this is less of a problem if you own a small number of prefs in different companies rather than a lot in one company, or if you plan to hold on to them for a long time.
4. Inflation Can Reduce Their Value
If the dividends on the preference shares are fixed in monetary terms (in other words with no inflation adjustment) then higher than expected inflation will reduce the real value of the dividends paid.
Also if inflation expectations change then the capital value of the preference shares might fall as investors require a higher return (i.e., a cheaper price) in order to buy them off you.
Preference shares can be thought of as an investment "in-between" equivalent shares and corporate bonds. Another kind of investment that also shares some qualities of both bonds and shares is commercial property.
Preference shares can be a valuable addition to an investment portfolio, particularly for an investor who wants a high income. But like all investments you need to make sure that this choice fits your needs and that you are willing and able to accept the risks that come with any investment.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2013 Cruncher