Preferential treatment

Thursday, 01 May 2014
John Harper provides an overview of preferred stocks and their various incarnations.

In a typical investment portfolio we usually meet shares (a.k.a. common stock, ordinary shares or equities) and bonds, the latter being no more or less than loans to the relevant company or government upon agreed terms. There is, however, a third type of security that is by no means uncommon: preferreds. As will be seen, they bear some of the investment characteristics of the other two types, while their risk and consequent return may lie somewhere in between. They are therefore often referred to as ‘hybrids’.

Preferreds are senior to common stock (i.e. higher ranking), but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). They usually have priority over common stock in the payment of dividends and upon liquidation. The precise terms of the preferred stock are described in the articles of association.

Preferreds bear some of the investment characteristics of shares and bonds, while their risk and consequent return may lie somewhere in between

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. As a consequence, they may offer a higher yield than regular bonds. Yields of 6 per cent and above are currently not uncommon on quoted preferreds. Other characteristics may include convertibility to common stock, callability (repurchase) at the option of the company, and no vote by holders at general meetings of the company.

Preferred stock may be cumulative or non-cumulative. A cumulative preferred requires that, if a company fails to pay a dividend (or part of one), it must make up for it at a later date out of future declared dividends. Dividends accumulate with each passed dividend period (which may be quarterly, semi-annually or annually). When a dividend is not paid in time, it has ‘passed’; all passed dividends on a cumulative stock make up a dividend in arrears. A stock without this feature is known as a non-cumulative, or straight, preferred stock; any dividends passed are lost if not declared. Where this feature exists, it is reasonable to suppose that the yield offered would be even greater, due to the increased risk of failing to achieve the expected return.

Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value, or as a fixed amount, e.g. ‘ABC Inc, 6 per cent, Series A Preferred’. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index, such as Libor.

Some preferred shares have special voting rights to approve extraordinary events (such as the issuance of new shares or approval of the acquisition of a company) or to elect directors, but most preferred shares have no voting rights associated with them; some preferred shares gain voting rights when the preferred dividends are in arrears for a substantial time.

Preferred stocks offer a company an alternative form of financing; in most cases, a company can defer dividends by going into arrears with little penalty or risk to its credit rating. With traditional debt, payments are required; missed payments would put the company in default and eventually bankruptcy.

Occasionally, companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill (or forced-exchange or conversion features), exercised upon a change in control. Some corporations include provisions in their charters authorising the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These ‘blank cheques’ are often used as a takeover defence; they may be assigned very high liquidation value (which must be redeemed in the event of a change of control), or may have great super-voting powers.

Because the income from a preference share is fixed, the share price will fluctuate according to interest rates, inflation and the credit rating of the company, in the same way as for bonds. The continued financial success and corresponding increase in profits of the company may well benefit the ordinary shareholder both in terms of increased dividend and share price. The same cannot be said for holders of preference shares. However, if it is income you are after, they may well form a part of your larger, balanced investment portfolio. However, as you may expect, their superior yield is naturally matched by a greater risk factor.

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John Harper

John Harper TEP is a part-time lecturer, delivering face-to-face courses for the STEP international diploma examinations all around the world.

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