In many ways, preferred shares act like fixed income. As with bonds, preferred shares may incorporate many different features, creating different types of shares.
Most of these are almost identical to the bond variants we looked at here and here. In fact, for any not listed below, you can look back at the bond features posts for further preferred share possible combinations.
Straight Preferred
These are your plain, vanilla preferred shares. The pay a fixed dividend rate and trade in the open market on a yield basis as if they were a bond.
For example, XYZ company issues 5.5% Cumulative Series H Preferred Shares at $25 per share. If comparative interest rates increase, the share price will fall to provide investors with the market yield. If general interest rates decrease, the share price will rise to again reflect the market returns.
Variable Rate Preferred
Also called “floating preferred”. These preferred shares are exactly the same as variable rate bonds. They pay a dividend that fluctuates with changes in interest rates.
For example, on January 1, 2017, ABC company issues Cumulative Series R Preferred Shares. These shares pay an annual fixed dividend of $2.00 per share until December 31, 2019. Beginning January 1, 2020, the dividend rate will float at a rate of 70% the average US prime rate of interest.
As with bonds of the same name, corporations normally include interest rates maximums and minimums to protect both themselves and shareholders from significant increases or decreases in interest rates.
Convertible Preferred
Like convertible bonds, the investor has the option to convert the preferred stock into another class of shares at a fixed priced within a specified date or period. Normally the option is to convert into the company’s common shares.
Because of the embedded option, a convertible preferred share will be priced somewhat higher than an equivalent straight preferred share. The premium paid by investors is the value of the embedded option.
The market value of straight preferred shares fluctuates based on general interest rate levels relative to the dividend paid. Convertibles though, are also affected by the market value of the shares that the preferreds may be converted into.
For example, each Convertco Cumulative Series B Preferred Share is convertible into 1.2 common shares of Convertco. On July 5, Convertco common shares traded at $20.50. At this price, the preferred shares would be worth $24.60 simply on the conversion factor alone ($20.50 * 1.2).
This would be the minimum value based on potential conversion. Because of the attached dividend, the preferred shares would actually be worth more.
As you pay a premium for the shares, you should believe in the underlying growth potential of the common shares. If not, then stick with straight preferreds and receive a higher yield on the dividend receipts.
Participating Preferred
Convertible preferreds provide the potential to capitalize on the growth of the issuing company. If the company grows and its common shares increase in value, you can convert your preferred shares to common shares (assuming that is the correct class) and benefit from the upside potential.
And, as we saw above, if the common shares have already increased in value, there will be a relative price increase to the preferreds as well, based on the conversion factor.
Participating preferreds also allow investors to benefit from the company’s success. In this case, it allows the preferred shareholders a right to a certain level of the company’s net earnings above the specified dividend rate.
This participation in the company’s net earnings comes in the form of a supplemental dividend, in addition to the normal payment. Often this is tied to the payment of dividends to common shareholders.
For example, Profitcorp has enjoyed a record year of earnings and cash flow. They are easily able to pay the dividends to holders of Profitcorp’s 10%, $25 Par Value, Cumulative Participating First Preferred Shares. With excess cash, Profitcorp decides to pay a $2.00 dividend to its common shareholders as well.
Under the terms of Profitcorp’s First Preferred Shares, any dividends paid to common shareholders must also be paid to holders of the First Preferred Shares at a rate of 50%.
In addition to the normal dividend of $2.50 (10% of 25 par value) received by the preferred shareholders during the year, they would also receive an incremental dividend of $1.00 (50% of $1 common share dividend).
As to the amount of extra dividends or the conditions for eligibility, one needs to review the relevant share documents.
Redeemable Preferred
Another one that we saw with bonds. Here the company holds an embedded call option on the shares. This allows the company to redeem some or all of the shares within a specified period of time.
If the company redeems the shares on a gradual basis, they usually utilize a “sinking” or “purchase” fund to do so.
As the company holds the option, they must pay for their privilege. As a result, the company will pay investors a premium for this option.
For example, in 2010, Callco issued 8% Cumulative Redeemable Series F Preferred Shares with a par value of $25. The shares were redeemable by Callco at $28 until December 31, 2015, $26.50 until December 31, 2020, and at par thereafter.
As you can see, if you owned shares that were redeemed in 2014, you would receive a $3 premium on each share ($28-25). But with the passage of time, the premium falls to $1.50 from 2016 through 2020, and then is zero after 2020.
Many companies issue redeemable shares. In part, because preferred shares often do not have a maturity date like bonds.
If a company wants to retire its debt, it can simply wait to maturity and then repay the principal. Of course, companies can utilize callable or redeemable bonds as well.
Minus any features, preferred shares cannot be cancelled except through repurchases on the open market. This can be expensive and may not result in being able to purchase and retire as many shares as the company desires.
Retractable Preferred
These give the shareholder the option to sell the shares back to the company at a specified price within a specified period.
As the option to sell now lies with the shareholder, there is a premium paid by the shareholder for this right.
Typically, if the retractable preferreds are not converted within a maximum time frame, they convert back to straight preferred shares.
That should provide a sense of what preferred shares are.
It should also illustrate why many consider them to be more debt than equity.
Next up, we will look at individual investments most of you own. Common shares or equity.
