Contents
- What are Preference Shares?
- Classification of Preference Shares
- Key Things to Consider When Buying Preference Shares
- How to Buy Preference Shares
- Selling Preference Shares
- Who Invests in Preference Shares?
- Rights Attached to Preference Shares
- Drawbacks of Holding Preference Shares
What are Preference Shares?
Preference shares, also referred to as preferred stocks, represent a class of ownership in a company that offers specific financial advantages over ordinary shares. The primary benefit is the prioritisation of dividend payments, where dividends are disbursed to preference shareholders before any dividends are paid to ordinary shareholders. This prioritisation also extends to the company’s assets in the event of bankruptcy, with preference shareholders receiving payouts before ordinary shareholders.
The structure and risk associated with preference shares can vary, making it essential for investors to thoroughly understand the specific terms and conditions of the preference shares they consider investing in. Each variant of preference shares might offer different levels of risk and returns, influenced by their specific dividend rates, redemption policies, and other terms that could affect their overall investment value.
Classification of Preference Shares
Preference shares are versatile financial instruments that blend elements of both debt and equity, leading to their classification as either hybrid or convertible securities. These shares can exhibit properties akin to bonds, such as having a fixed maturity date, and can be issued by both private and public companies. Publicly listed preference shares are traded on the Australian Stock Exchange (ASX).
Types of Preference Shares
Convertible Preference Shares
These shares are initially issued with fixed dividend payments, which are paid out at regular intervals. At a predetermined time and rate, convertible preference shares can be transformed either into ordinary shares or redeemed for cash, providing flexibility in investment strategy and potential for capital growth.
Converting Preference Shares
Distinct from convertible preference shares, converting preference shares are designed to eventually convert into ordinary shares. This conversion is typically executed at a specified dollar amount, aligning the investment‘s outcome closely with the performance of the company‘s ordinary shares.
Cumulative Preference Shares
For cumulative preference shares, if a company is unable to pay dividends when due, these dividends accumulate rather than lapse. The accrued dividends are then paid out once the company regains financial stability. Ordinary shareholders only receive dividends after all owed dividends to cumulative preference shareholders have been fully paid, providing a layer of security for investors regarding dividend payments.
Redeemable Preference Shares
These shares come with the option for the company to buy them back, which allows shareholders to redeem their shares for cash. The terms of redemption, including the timing and the price, are typically at the company’s discretion, offering companies flexibility in managing their equity structure.
Each type of preference share offers unique characteristics and risks, making them suitable for different investment strategies and objectives. Understanding these variations is crucial for investors looking to tailor their portfolios to specific financial goals.
Key Things to Consider When Buying Preference Shares
When contemplating an investment in preference shares, several key aspects should be evaluated to understand the potential benefits and risks associated with such securities.
Dividend Rate and Structure
Investors should first ascertain the dividend rate of the preference shares, which can be either fixed or floating. A fixed dividend rate provides predictable returns, offering stability in income generation. Conversely, a floating dividend rate varies with market conditions, typically pegged to a benchmark interest rate, introducing variability in potential returns.
Tax Treatment of Dividends
The tax status of the dividends, specifically whether they are franked, is another important consideration. Franked dividends come with a credit for taxes the company has already paid, which can reduce the gross tax liability for the shareholder. This tax advantage can significantly affect the net return on investment from preference shares.
Conversion Terms
Understanding the terms under which preference shares can convert into ordinary shares is crucial. This includes knowing when the conversion can happen and the conditions under which it occurs, such as at the investor‘s discretion or triggered by specific events. The conversion feature can impact the investment’s growth potential and risk profile, as converting into ordinary shares might expose the investor to the volatility of the equity market.
How to Buy Preference Shares
When a company issues preference shares, it accompanies the release with a prospectus. This document is vital as it details the features of the shares, associated risks, and other relevant information that potential investors need to make informed decisions.
Purchasing Channels
Preference shares can be purchased directly from the issuing company at the time of their release. Alternatively, once these shares are listed, they can be bought through a broker on the Australian Stock Exchange (ASX). When purchasing from the ASX, investors will pay the market price, which can differ from the initial issue price depending on current market conditions.
Selling Preference Shares
Maturity and Conversion
Most preference shares have a maturity date at which they are either converted into ordinary shares or redeemed. Typically, this conversion happens at a rate that might be discounted relative to the market price at the time of conversion, providing a potential advantage or disadvantage depending on market conditions.
Selling Before Maturity
If an investor decides to sell preference shares before they reach maturity, they must do so on the ASX. The selling price will reflect the market value at that time, which could be higher or lower than the face value or the price initially paid. This market dependence introduces a level of risk as the return on investment can vary based on timing and market conditions.
Who Invests in Preference Shares?
Preference shares attract a specific type of investor, generally those seeking a more secure form of investment compared to typical equity instruments like stocks or bonds. These shares are appealing because they offer fixed income returns, which provide stability and predictability in investment outcomes.
This characteristic makes preference shares particularly suitable for investors who prioritise income certainty over the potential for high capital gains.
However, the security and fixed income features of preference shares can also limit their appeal to a broader investor base. Unlike ordinary shares, which can attract a wide range of investors due to the potential for high returns through capital appreciation, preference shares do not offer the same level of upside.
As a result, the pool of investors interested in preference shares is often narrower, which can pose challenges for companies attempting to raise significant capital through the issuance of preference shares. This situation often makes it more challenging for companies to rely solely on preference shares for large fundraising needs.
Rights Attached to Preference Shares
Preference shares offer shareholders preferential treatment compared to ordinary shareholders in several key financial aspects, making them an attractive option for investors seeking greater security.
Voting Rights
Often, preference shares do not come with voting rights. This absence of voting privileges differentiates them from ordinary shares, which typically allow shareholders to vote on corporate decisions.
Dividend Rights
Preference shares are often structured to provide priority dividends. The governing documents of a company, such as its bylaws or shareholder agreements, detail these rights. Typically, dividends to preference shareholders are either a fixed percentage of their investment or are prioritised over dividends to ordinary shareholders.
This setup provides preference shareholders with a higher certainty of receiving a return on their investment before any dividends are distributed to ordinary shareholders.
Liquidation Preferences
In the event of company insolvency, preference shareholders have superior rights over ordinary shareholders concerning asset distribution. They are typically entitled to recover either the original amount invested or an amount based on how assets would be divided among all shareholders, whichever is greater.
This right is termed as a liquidation preference. Additionally, any preferential dividends that preference shareholders receive are usually subtracted from the total amount they obtain during the liquidation process.
Participating Liquidation Preferences
Some preference shares come with a fully participating liquidation preference, which is particularly favourable for investors. This arrangement not only allows preference shareholders to recover their initial investment in the event of liquidation but also enables them to share in any remaining company profits alongside ordinary shareholders.
This dual benefit allows them to double dip, maximising their potential returns from the investment.
These features highlight why preference shares are favoured, especially in startup investments, as they provide financial protections and benefits that are not typically available to ordinary shareholders.
Drawbacks of Holding Preference Shares
Lack of Voting Rights
One of the significant disadvantages of holding preference shares is the lack of voting rights. This can be a critical drawback for investors who wish to have a say in the company‘s management and decisions. Unlike ordinary shareholders who typically have voting rights at shareholders‘ meetings, preference shareholders usually do not influence managerial decisions, which can affect their control over their investment.
Fixed Dividend Rates
Although the fixed dividends associated with preference shares provide a predictable income, this can also be a limitation. Fixed dividends mean that preference shareholders do not benefit from increases in the company‘s profitability beyond the agreed rate. In times of significant profit growth, ordinary shareholders might receive substantially higher dividends, whereas preference shareholders are capped at their fixed rate.
Limited Upside Potential
Related to the fixed dividend rate is the limited upside potential of preference shares. Because they typically do not appreciate in value in the same way that ordinary shares can, preference shareholders might not benefit from increases in the share price due to market growth or company performance. This limitation can make preference shares less attractive during bull markets when investors could gain more from capital appreciation.
Complexity in Conversion and Redemption
Preference shares often come with options for conversion to ordinary shares or redemption at certain times under specific conditions. These features can introduce complexity and uncertainty regarding the timing and value of conversions and redemptions. Investors need to understand these terms fully, as poor timing or unfavourable market conditions at the time of conversion or redemption can lead to suboptimal financial outcomes.
Market Liquidity
Preference shares might have lower liquidity compared to ordinary shares, especially if they are not widely traded. This lower liquidity can make it more difficult for investors to sell their shares quickly without impacting the price, potentially leading to less favourable selling conditions.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.