What are preferred shares?
Preferred shares are often called hybrid securities. They have the properties of both stocks and bonds. They resemble stocks in that they are classified as equity investments, trade on an exchange and pay dividends. Unlike common stocks, they generally carry no voting rights. But the dividend is fixed – rather than declared and has priority over the common stock (hence the “preferred” label).
At the same time they resemble bonds in that they pay a steady stream of income and are impacted by the same factors that affect bonds. Because of their fixed payments, preferred shares are interest-rate sensitive. Also, in the unlikely event of a corporate liquidation, preferred shareholders stand ahead of common stock holders (but are secondary to bond holders).
Types of preferred shares?
There are several types of preferred shares I have a list below from Wikipedia, but there are three main types of preferred shares.
Fixed resets preferred- fixed or rate resets pay a fixed dividend for five years then are reset based on where interest rates are after that time.
Floating preferred- pay a floating dividend that is based on the prime rate. These do better in a rising rate environment.
Perpetual preferred- pay a fixed dividend in perpetuity (or until the issuer redeems them). Perpetuals generally outperform in a declining rate environment.
Prior preferred stock—Many companies have different issues of preferred stock outstanding at one time; one issue is usually designated highest-priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the payments on the prior preferred. Therefore, prior preferreds have less credit risk than other preferred stocks (but usually offers a lower yield).
Preference preferred stock—Ranked behind a company’s prior preferred stock (on a seniority basis) are its preference preferred issues. These issues receive preference over all other classes of the company’s preferred (except for prior preferred). If the company issues more than one issue of preference preferred, the issues are ranked by seniority. One issue is designated first preference, the next-senior issue is the second and so on.
Convertible preferred stock—These are preferred issues which holders can exchange for a predetermined number of the company’s common-stock shares. This exchange may occur at any time the investor chooses, regardless of the market price of the common stock. It is a one-way deal; one cannot convert the common stock back to preferred stock. A variant of this is the anti-dilutive convertible preferred recently made popular by investment banker Stan Medley who structured several variants of these preferred for some forty plus public companies. In the variants used by Stan Medley the preferred share converts to either a percentage of the company’s common shares or a fixed dollar amount of common shares rather than a set number of shares of common. The intention is to ameliorate the bad effects investors suffer from rampant shorting and dilutive efforts on the OTC markets.
Cumulative preferred stock—If the dividend is not paid, it will accumulate for future payment.
Exchangeable preferred stock—This type of preferred stock carries an embedded option to be exchanged for some other security.
Participating preferred stock—These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance (assuming the company does well enough to make its annual dividend payments). If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.
Perpetual preferred stock—This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder (although there are redemption privileges held by the corporation); most preferred stock is issued without a redemption date.
Putable preferred stock—These issues have a “put” privilege, whereby the holder may (under certain conditions) force the issuer to redeem shares.
Monthly income preferred stock—A combination of preferred stock and subordinated debt.
Non-cumulative preferred stock—Dividends for this type of preferred stock will not accumulate if they are unpaid; very common in TRuPS and bank preferred stock, since under BIS rules preferred stock must be non-cumulative if it is to be included in Tier 1 capital.
Supervoting stock—a “class of stock that provides its holders with larger than proportionate voting rights compared with another class of stock issued by the same company.” It enables a limited number of stockholders to control a company. Usually, the purpose of the super voting shares is to give key company insiders greater control over the company’s voting rights, and thus its board and corporate actions. The existence of super voting shares can also be an effective defense against hostile takeovers, since key insiders can maintain majority voting control of their company without actually owning more than half of the outstanding shares.
There is a common debate over preferred shares as to whether they should be classified as bonds or as equity. The main advantage of preferred shares is that they pay attractive quarterly dividends to shareholders and because they pay dividends rather than interest, you are able to claim the dividend tax credit.
With preferred shares, you get an attractive fixed yield, a more secure position than common stockholders get, more favorable tax treatment than with interest-bearing securities. Preferred shares are less volatile than common stocks, but during the financial crisis, they dropped 70% as much as the S&P 500 but quickly rebounded during the recovery.
Stock or bond ? You decide, I class them as dividend stocks but preferred shares might have a place in your portfolio if you are looking for income, safety and broader diversification.
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