Preferred Shares

What Is Preferred Shares?

Preferred shares are a type of equity investment that represents ownership in a company, similar to common stock, but with distinct features that give them precedence over common shares. They are typically considered a hybrid security, blending characteristics of both fixed income securities like bonds and traditional equity. Investors holding preferred shares generally receive a fixed dividend payment before common shareholders are paid, and they also have a higher claim on a company's assets in the event of liquidation or bankruptcy. Preferred shares play a significant role in a company's capital structure as a means of raising capital.

History and Origin

The concept of preferred stock emerged in the mid-19th century in the United States, with the Pennsylvania Railroad Company often cited for issuing the first preferred stock. These early shares were designed to offer investors a more stable income stream through higher dividend payouts and a priority claim on company assets, particularly in the event of financial distress. Preferred shares became more widely adopted in the early 20th century by public utilities and transportation companies seeking to raise capital while providing a security that appealed to investors looking for predictable income.¹⁴

Key Takeaways

• Preferred shares generally offer a fixed dividend payment that takes precedence over common stock dividends.
• In a company's liquidation, preferred shareholders have a higher claim on assets than common shareholders but are subordinate to bondholders and other creditors.
• Unlike common stock, preferred shares typically do not carry voting rights.
• Preferred shares are often considered a hybrid security, combining features of both stocks and bonds.
• Their market price can be sensitive to changes in interest rates.

Formula and Calculation

The current yield of a preferred share is a key metric, indicating the annual dividend payment relative to the share's current market price. This is particularly relevant given that the market price of preferred shares can fluctuate from their par value.

The formula for calculating the current yield of a preferred share is:

For example, if a preferred share has an annual dividend of $5 and is currently trading at $90 per share, its current yield would be:

This calculation helps investors compare the income potential of different preferred shares and other income-generating investments.

Interpreting Preferred Shares

Interpreting preferred shares involves understanding their hybrid nature and how their features can influence an investment portfolio. While preferred shares offer a more stable dividend income and a higher position in the capital structure during liquidation compared to common stock, they typically lack the capital appreciation potential often associated with common stock.¹³ Investors often consider preferred shares for their income-generating capabilities, which can be particularly attractive in periods of stable or declining interest rates. Their fixed dividend payouts mean that, like bonds, their market price tends to move inversely to interest rates.¹² When interest rates rise, newly issued securities may offer higher yields, making existing preferred shares with lower fixed dividends less attractive, leading to a decrease in their market value.

Hypothetical Example

Imagine "TechInnovate Inc." needs to raise capital for a new expansion project. Instead of issuing more common stock, which might dilute existing shareholders' voting power, or taking on more debt, they decide to issue 100,000 shares of 6% cumulative preferred stock with a par value of $25 per share.

This means TechInnovate Inc. promises to pay an annual dividend of $1.50 per share (6% of $25 par value) to preferred shareholders. These dividends must be paid before any dividends are distributed to common stockholders. If, in a challenging year, TechInnovate Inc. cannot pay the preferred dividend, because the shares are cumulative, the missed payment will accrue and must be paid in future periods before common dividends can resume. This cumulative feature provides an added layer of security for the preferred shareholders' income stream. An investor who purchases 100 shares of this preferred stock would expect to receive $150 in annual dividends. This highlights the income focus often associated with preferred shares.

Practical Applications

Preferred shares are used by companies to raise capital without diluting the voting control of existing common shareholders, as preferred shares typically do not carry voting rights.¹¹ They are also a means for companies to shore up their financial statements and improve their debt-to-equity ratio, as preferred stock is classified as equity rather than debt. Financial institutions, such as banks and insurance companies, are prominent issuers of preferred stock, often to meet regulatory capital requirements.¹⁰

During periods of financial instability, preferred shares have also played a role in government intervention programs. For instance, during the 2008 financial crisis, the U.S. government acquired preferred stock in major banks as part of recapitalization efforts through the Troubled Asset Relief Program (TARP), injecting capital into the financial system., This mechanism allowed the government to provide support and stabilize institutions while gaining a preferred claim on future returns.

The Internal Revenue Service (IRS) provides guidance on the tax treatment of dividends received from preferred shares.⁹ For many preferred shares, the dividends may qualify for a lower tax rate than ordinary income, similar to qualified dividends from common stock, provided certain holding period requirements are met.,⁸ This potential tax advantage can enhance the after-tax yield for investors.

Limitations and Criticisms

Despite their advantages, preferred shares have limitations. One primary criticism is their limited capital appreciation potential; unlike common stock, their value does not typically rise significantly with the company's growth beyond their par value.⁷ Investors primarily seek preferred shares for their stable income, not for substantial stock price gains.⁶

Preferred shares are also subject to interest rates risk. When interest rates rise, the fixed dividends offered by existing preferred shares become less attractive compared to new issues or other fixed-income investments, causing their market value to decline.⁵,⁴ This makes them sensitive to changes in the broader economic environment.

Another significant drawback for investors is that preferred shares usually do not grant voting rights.³ This means preferred shareholders have no say in corporate governance or strategic decisions, distinguishing them sharply from common stock ownership. Additionally, many preferred shares are callable, meaning the issuing company can redeem them at a specified price after a certain date, often when interest rates have fallen.² This callable feature limits an investor's potential for ongoing income if the shares are redeemed, particularly if the investor bought the shares at a premium. Although preferred shares have priority over common stock in liquidation, they are still subordinate to all forms of debt, including callable bonds and other creditors. This position in the capital structure means that in a severe bankruptcy, preferred shareholders may still face significant losses.

Preferred Shares vs. Common Stock

The key distinctions between preferred shares and common stock lie in their rights, risk profile, and potential returns. Preferred shares offer preferential treatment in receiving dividend payments and a higher claim on company assets during liquidation. Dividends on preferred shares are typically fixed and paid out before any common stock dividends. In contrast, common stock dividends are variable and dependent on the company's profitability. Common stockholders, however, generally possess voting rights, giving them a say in corporate decisions and the election of the board of directors, a right typically absent for preferred shareholders. From a risk perspective, preferred shares are considered less risky than common stock due to their priority in dividends and asset claims, but they offer limited potential for capital appreciation compared to common stock, which can see significant price increases if the company performs well.¹ Common stockholders are residual claimants, meaning they only receive assets after all other obligations, including preferred shareholders, have been satisfied.

FAQs

Q: Do preferred shares have voting rights?
A: Typically, no. Preferred shares are generally non-voting, meaning holders do not have a say in corporate governance or company decisions, unlike common stockholders.

Q: Are preferred share dividends guaranteed?
A: While preferred share dividends have a priority claim over common stock dividends, they are not guaranteed. A company's board of directors can choose to suspend dividend payments if the company faces financial difficulties. However, for cumulative preferred shares, any missed dividends must be paid later before common shareholders can receive any dividend payments.

Q: What happens to preferred shares if a company goes bankrupt?
A: In the event of a company's bankruptcy and subsequent liquidation, preferred shareholders have a higher claim on the company's remaining assets than common stockholders. However, their claims are still subordinate to those of bondholders and other creditors.

Q: Can preferred shares be converted into common stock?
A: Some preferred shares are convertible securities, meaning they can be exchanged for a predetermined number of common stock shares. This feature provides investors with the potential to participate in the company's growth if the common stock performs well.

Q: How do interest rates affect preferred share prices?
A: Preferred share prices generally have an inverse relationship with interest rates. When interest rates rise, new fixed-income securities offer higher yields, making existing preferred shares with lower fixed dividends less attractive, which can lead to a decrease in their market price. Conversely, when interest rates fall, preferred share prices tend to rise.