Investing in Preferred Shares vs. Bonds, Common Stock
August 29, 2012
For most people, bonds and equity (common stock) are the usual options for investment. We have already discussed these two asset classes lengthily. For a refresher course, here’s our primer on Stock Trading and Investing while here is a tutorial on Bonds and Fixed Income.
We now talk about an alternative investment option: Preferred Stocks or Preferred Shares.
What are Preferred Stocks?
A Preferred Stock is a type of equity security that generally has the properties of both debt and equity. Similar to debt instruments, preferred shares receive a fixed amount of income, called dividends, at regular, known periods. Although there is assurance of the dividend income rate, dividends must still be declared by the Board of Directors and may be skipped or deferred, as in the case of common stocks. It can thus be said that the class of preferred stocks lie between the asset classes of bonds and common equity.
What are the features of Preferred Shares vs. Bonds and Common Stocks?
Fixed rate of income. The dividend rate of a preferred stock is fixed and announced to the public upon issuance. This characteristic is shared with fixed-income securities like bonds, reducing investor’s risks by guaranteeing a fixed amount of income and ensuring predictability of payment. However, unlike the dividends issued to common stocks, this dividend rate is capped and cannot be revised upwards (except for participating preferred shares), thus when times are good for the company, preferred stockholders do not get additional or any residual income. Of course, when times are bad, this feature provides protection to preferred stockholders who know how much they will receive, unlike common stockholders, who may not get any dividend income at all during the year.
Declaration of dividends. Although the income rate is fixed and guaranteed, the actual payment of dividends is not. Similar to common stocks, dividends must first be approved and declared by the Board of Directors before they are distributed to stockholders. Some preferred shares, however, have a cumulative option that guarantees payment even if the year’s dividends are skipped. (Related reading: Tutorial on Ex-Dividend Date, Record Date, Dividend Declaration Date)
Cumulative vs. Non-cumulative option. When times are bad, a company may opt to forego distribution of dividends — to both common and preferred stockholders. If the preferred stocks are cumulative, the dividends are not lost but merely deferred, and they accumulate and accrue until the next dividend payment period. If the company recovers, cumulative preferred shareholders get to to receive these “dividends in arrears.” Non-cumulative or straight preferred stocks, on the other hand, function like a regular common stock. If dividends are not declared, they are skipped and forever lost and non-cumulative preferred shareholders do not anymore get the right to receive them in succeeding periods.
Non-voting. Most preferred shares usually carry the non-voting option, which means holders cannot vote on matters affecting the business and thus cannot have a say in the management of the company.
Seniority in claim. In the worst case that the company is liquidated, preferred shares have seniority in claim compared to common stocks. This means preferred shareholders are paid their capital, plus any accrued, unpaid dividends, ahead of common stockholders. Common stockholders, on the other hand, have a residual claim, entitling them to receive what is left of the company. Preferred stockholders, meanwhile, have a subordinate claim compared to the company’s bondholders and other creditors and they are only paid once the company’s creditors have been repaid.
Convertibility. Some preferred shares may be converted to a certain number of common shares, giving investors voting right and residual claim on the company. The convertibility period usually is announced by the company, while in some cases, the preferred shares can be converted to common stock anytime the investor desires.
Callability. Some companies issue callable preferred shares, which give the company the option to repurchase shares at predetermined terms and conditions. The par value of the shares and any dividends in arrears, plus any rate adjustments accompanying the call option, are paid to investors when shares are called and redeemed.
Participating. To increase the attractiveness of preferred shares, some issuers attach a participating option which increases the income potential of the shares. If a company achieves predetermined financial goals, participating preferred shareholders get to receive an additional dividend on top of the regular, fixed dividend.
How do I make money from Preferred Shares?
The primary source of income in preferred shares is the fixed dividends which may be cumulative or non-cumulative. If dividends are cumulative, the investor gets to receive these dividends in succeeding periods, if the company decides to defer payment in the preceding period. If non-cumulative, then dividends are foregone and will be unpaid in the future. (See also: Top 10 Stocks with High Dividend Yield)
Another way to make money from preferred shares is through capital appreciation. Several preferred stocks are actively traded on the market and can be bought or sold at any time. Some local companies that have issued preferred shares that are traded on the Philippine Stock Exchange include Ayala Corporation, PLDT, Purefoods Corp., First Gen Corp., First Philippine Holdings, and Globe Telecom, among others.
How do I invest in Preferred Shares?
For shares that are have been previously issued, you can trade them on the Philippine Stock Exchange like any regular common stock. For new issuances, you can get information from your broker or other financial institutions that underwrite them.
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Other useful readings:
- PMT’s Primer on Stock Trading
- Investing in Bonds and Fixed Income
- List of available Investment Products
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