Preferred Shares

Equity

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Curriculum Content

Common shares are not the only type of Equity, simply the most ordinary. The other type of equity is known as “Preferred Equity”. Preferred Shares functions similarly to debt. If you own Preferred Shares, you pay the firm for the ownership of the share and receive regular dividend payments. This continues even if the value of dividends exceeds your purchase price, until you sell or relinquish the preferred shares. These dividend payments will be paid to you quarterly or annually, depending on the dates set by the firm for payment.

It is direly important to note that firms always have the discretion to pay dividends, they are not a requirement. In exchange unpaid dividends may accrue until they are paid, but this is reliant on the preferred equity contractual agreement. Depending on the contract, preferred shareholders may also impose restrictions on shares until the dividends are paid. Firms cannot pay dividends to any Common Shareowner until they’ve fully paid all accrued dividends to Preferred Shareholders. If common shareholders are accustomed to a dividend they may utilize voting powers to intervene and pressure management into payments for preferred shareholders. The same may occur if preferred stock owners are also common shareholders.

Preferred Shares is sometimes callable by the issuing firm. “Callable” means that the firm can revoke the preferred shares, ending the future dividend payments. If preferred shares are callable, this must be written into the contracts for the shares.

Preferred shares have no voting powers or control over the firm. Owners of preferred shares cannot vote unless they own common shares, and their ownership of preferred shares does not increase their control. In exchange, many firms create “Convertible” preferred equity, which allows a shareowner to convert their Preferred Shares to Common Shares. This occurs at the shareholder’s option; firms may not force preferred shareowners to convert their preferred shares to common shares. The conversion rate is a specified conversion ratio stated at sale. Occasionally, the conversion ratio is a variable rate which changes based on the interest rates of the market.

Preferred Shares are drastically different from Common Shares in terms of the risks they can potentially pose to owners. There are risks associated with preferred shares. These risks are Call Risk, Dividend Suspension, and Maturity Risk. These risks change with the contractual agreements written into the shares. Check the preferred share contracts before purchasing.

Call Risk

Firms can revoke their preferred shares if those shares have a call provision. This means in any situation, the issuing firm can essentially cancel their agreement to pay dividends. You should always check if their preferred shares have a call provision, avoiding them whenever possible.

Why would a provider of preferred shares ever revoke sold preferred shares? Call risk is based on interest rate and preferred share interaction. If interest rates fall, any investment instrument with a fixed rate of return above the interest rate increases in value, and firms now can release instruments with interest rates below the old rate. Preferred shares pay a fixed dividend rate, which is set and controlled by the firm. The firm can raise or lower the dividend rate, but it does not automatically rise or fall with the interest rate itself, nor does it automatically adjust for inflation.

Firms will usually raise the dividend rate above the interest rate in order to sell preferred shares to new investors if they need to raise capital. The problem comes with interest rates fall. If a firm is paying dividends on callable preferred shares above a high interest, when the interest rate falls they can simply call the preferred shares. They can issue new preferred shares paying a similar value to the lower market interest rate. Callable preferred share dividend rates that are substantially above lowered interest rates are highly likely to be called.

If interest rates rise, preferred share rates might be below the new interest rate. The value of shares will decrease unless the rates are raised above the higher interest rates. If the firm does not need to acquire more funding, they may not raise the dividend amount. Increasing the rate of return would require them to deliver more money to the investors. The firm may rather reinvest the money, or they might want investors to purchase new preferred shares. They would only raise the fixed dividend payout if they want to reward preferred shareholders or if they are seeking new capital through preferred shares.

Firms are wise to call the shares. By calling the shares they can save money which they deliver to retained earnings. The problem is that callable preferred shares expose you to lopsided risk. If interest rate falls you might lose your dividend stream if it is substantially above interest rates, and you will be forced to reinvest their money at lower interest rates. If interest rates rise, there is little reason for the firm to increase your dividend returns. Avoid callable preferred shares if possible.

Credit Risk

Credit risk is the possibility that an issuer of a long term income stream will default on their obligations. The closer a firm comes to bankruptcy or failure, the higher the firm’s credit risk. If a firm is experiencing financial turbulence, preferred shareholders stand to lose their income stream. Firms may reduce their dividends paid per share to you in times of difficulty. They also may cease paying dividends for a period of time, or revoke callable preferred shares.

Preferred shares may be issued by firms with bad credit scores or risky financials because they are avoiding paying high interest rates on bonds. If a highly risky firm extends loans, it will have to pay high interest rate payments to compensate for that risk. If a risky firm releases preferred shares, they can reduce dividends payouts at a later date or call the shares issued.

You should avoid credit risk by researching the financial standing of the firm. Since preferred shares can have a (usually extremely long term) maturity date, it is important to regularly review the financial standing of the firm. You should avoid purchasing preferred shares from companies with high amounts of debt or shaky financials. If you purchase non-callable bonds from a risky firm, you will receive a substantially higher interest rate that cannot be called or suspended. If that firm fails or enters bankruptcy, you will be among the first in line to receive reimbursement. Bondholders get reimbursed first. Preferred shareholders are reimbursed just before common shareholders.

Dividend Suspension

Preferred shares are not required to pay dividends to shareholders. Suspension risk is the largest potential downside for preferred shareholders after credit risk. A suspension of dividends results in significantly lower returns for preferred shareholders. To add insult to injury, there is no requirement to reestablish dividends unless the firm is paying dividends to common shareholders. If the firm wishes to pay common shareholders dividends, they must reimburse all dividends unpaid to cumulative preferred shareholders. It’s important to note that if the firm is financially stressed and has accrued unpaid preferred shareholder dividends, they simply wouldn’t pay common shareholder’s dividends. This would avoid having to pay cumulative preferred shareholder’s dividends.

If there are no common shareholders, there’s no need to reimburse preferred shareholders for missed dividend payments. You should always ensure that their preferred shares are cumulative for previous reimbursements.