Preferred shares don’t get the attention they used to – but they can play a very important part of investors’ portfolios – especially in non-registered portfolios. So what is a Preferred Share?
Many people point out that a preferred share lies somewhere between a common stock and a bond both in terms of returns and in terms of risk – and that’s a good starting point for the discussion. We know that a common share is an equity investment in that you OWN part of the company when you own a common share. Also, you MIGHT receive dividends on your common shares if so declared by the company – and you will certainly participate in the stock market’s evaluation of what the company is worth (i.e. you can make a profit or loss based on what the price of the stock does). We also know that a bond is a DEBT investment – you don’t own any part of the company, you are simply lending them money – for which they pay you interest.
A preferred share is a little bit of both in a sense. It actually represents equity in the company (so that makes it more like a common share). The price of the preferred share doesn’t fluctuate very much relative to the price of the common stock but the price of the preferred share DOES react more relative to changes in interest rates (again, making it more like a bond). A preferred share also pays a dividend which is a fixed amount whereas a common share may adjust it’s dividend more freely (yet again, sounding more and more like a bond).
Another fact often cited when comparing the three types of securities is how they are treated upon insolvency of the underlying company. So what would happen when a company "went under"? Bondholders are first in line to recieve any value left in the physical assets of the company, followed by the preferred share holder and if there is anything left then the common shareholder would get there share (which in all practical cases is nothing!).
So let’s recap a little first: A preferred share represents an equity investment in a company, but think of it more as ownership of part of the earnings of the company – hence a fixed dividend payment. The price of the preferred share fluctuates more like a bond (so not much price movement versus a common stock) and therefore is less risky than a common share. The preferred shareholder is next in line when it comes to claiming assets after the bond holders and BEFORE the common share holder – so it is a bit more risky than a bond.
Perhaps to make it a little more clear as to how it would fit into a portfolio – I personally view them as bonds with a little more risk that are suitable for placement in non-registered portfolios first and foremost. This is because instead of receiving interest (like with a bond which is taxable at 100% of your marginal tax rate) it is dividend income which is taxed more preferentially than interest income. So for example, if you were in the top tax bracket a preferred share with a dividend yield of 5% is like owning a bond with an interest yield of 8.5% since after taxation you have the same amount of money in your pocket (again, this only applies to non-registered or taxable accounts).
- Preferred shares are also rated by credit agencies just like bonds except they will have ratings like P1 and P2 as opposed to AAA, AA, A, BBB, etc. with bonds.
- When a company declares dividends, preferred shareholders are entitled to receiving the dividends first and then what’s left of the dividend can be distributed to the common shareholder (if anything is left over!)
- "Perpetual" dividends have no maturity date per se and could potentially exist forever, paying the dividend in perpetuity as well.
- "Cumulative Preferred Shares" are a type of preferred share that stipulates that if a company misses making a dividend payment, the preferred shareholder is entitled to be paid that dividend in the future when the company returns to profitablility. A "Non-cumulative" preferred share stipulates that if a company skips a payment of the dividend due to lack of profits or retained earnings then the shareholder is out of luck – this is rare however as the preferred shareholders would seek other investments if they felt there was a danger of this happening again – since preferred shareholders buy preferred shares for income purposes.