Today we will look at preferred shares.
Although a form of equity, I generally consider preferred shares as fixed income. The characteristics of preferreds make them more like debt than equity. For asset allocation purposes, I normally include preferred shares with fixed income.
So what exactly is this hybrid asset that lies somewhere between debt and equity?
Ownership in the Company
Preferred stock is a means of ownership in a corporation. As part of a company’s ownership structure, preferred shares are part of shareholder equity on the balance sheet.
This differs from debt instruments which are merely loans to the issuer by the debt holder. As loans, debt is a liability of the issuer. Bond holders may have claims to specific assets upon default, but they are not owners of the issuing entity.
As preferred shares are equity in the company, there is no natural maturity date as with most debt. Although, as we will see later, a maturity feature may be added to the shares.
Preferred Status
As the name suggests, preferred shares have a priority to the company’s assets and earnings over common shares. However, usually debt issues have priority than preferred shares.
A higher claim on assets is important if the company breaks up, intentionally or not. If this occurs, preferred shareholders will be paid the par value of their shares before common shareholders.
The prioritized claim to earnings is crucial for dividend receipts. Dividends payments require adequate cash flow and earnings to ensure an uninterrupted stream to shareholders.
Dividends Not Capital Appreciation
Dividends are the main reason investors purchase straight preferred shares. Like bond coupons, preferred shares normally have a fixed dividend that is paid out quarterly (bonds usually pay semi-annually).
While many investors in common shares do enjoy dividends, the main motivation is the potential for capital gains. Again, this aligns preferred shares more in the debt than equity investment realm.
That said, there may indeed be capital gains (or losses) on preferred shares if sold.
As with bonds, the market value of preferred shares move in opposite directions to changes in interest rates. As general rates increase, preferreds with fixed rate dividends will fall in price. If rates decrease, the price of the shares will rise to reflect the lower yield in the marketplace.
Depending on the specific preferred share issue, there may or may not be participation in the company’s performance. If not, the shares will react in price as if they were bonds. If there is participation, the share price will reflect that.
Dividends Not Interest Income
Bonds pay investors interest on debt. Preferred and common shares pay dividends from accumulated retained earnings.
In many jurisdictions, including Canada, eligible dividends may be taxed at a preferential rate versus interest income. If so, then on an after-tax basis you will net more cash from a dividend than interest income at the same gross amount.
If you earn 8% interest and 8% in eligible dividend income, you will be better off owning the preferred (or common) shares than the bonds. The exact advantage will be based on the preferential tax treatment and your own tax status.
Tax treatment on interest, dividends, and capital gains varies significantly between tax jurisdictions. Taxation is a major investment consideration. Investors should gain, at least, a basic understanding of the differences.
Not All Dividends Are Taxed the Same
As well, not all income in a specific class may be treated the same for tax purposes.
In Canada, for example and writing in generalities, an eligible Canadian public corporation’s dividends may allow for a gross up and tax credit. Canadian private corporation dividends may or may not be eligible depending on the company’s tax situation. Foreign corporations generally are not eligible for the tax credit. You need to understand the different types of dividend income received, as that will impact your after-tax returns.
If you own shares or funds listed on foreign exchanges, withholding taxes may be deducted before paying out your dividends. Often you can “recover” via tax treaties, but be aware of this on foreign sourced income.
Dividends Must Be Declared
Interest on bonds is based on the loan terms. Interest is paid out of cash flow. If the company is unable to make an interest payment, that money accumulates and is paid as soon as possible.
Dividends are paid out of retained earnings and must be declared by the company. Preferred share dividends are paid out prior to any dividend payments to common shareholders. Understand the conditions for when dividends may or may not be declared. If you invest to earn dividends, you will want to receive them.
For “cumulative preferred shares”, any unpaid dividends accrue over time and must be paid in full before any other dividends are paid. Again, this is much like bond issues. If investors do not get paid, the interest or dividends owing cumulate and are back-paid. It is much better to invest in preferred shares that are cumulative in nature.
No Voting Rights
Like bonds, preferred shares typically carry no voting rights within the company. Voting normally resides solely with common shareholders.
However, if dividend payments have been missed by the company for a period, often the preferred shareholders are granted voting rights on a contingent basis (usually while the dividends are in arrears). Bondholders, too, may have some say in company operations while interest payments are in arrears.
While the above is generally true, like bonds, there are many permutations of preferred shares.
Also, companies may issue various classes of preferred shares with different features. These classes may rank equal in their rights or some classes may be subordinate in their claim to assets and earnings.
As was the case in our bond review, knowing the details for each issue is important.
Next up, we will review common preferred share features. Many are identical to bond features.
