Let us start with common or ordinary shares. In the broadest definition these are usually voting shares representing proportional ownership of the firm and they sometimes pay dividends.
Because they represent the ultimate ownership of the company, they are usually last in line if the company goes into liquidation. Employees, creditors and bondholders have priority. Common shares are usually the top choice for investors looking to participate in the growth of the business.
Preferred, or preference, shares bear the name because of the advantages they offer the holder:
• Seniority to common (or ordinary) shares
An advantage in the event of liquidation, although the shares are subordinate to bonds in this event.
• Pay-established dividends.
Attractive to investors seeking an income vehicle.
• Priority
Preferred dividends must be paid before common stock dividends.
• Cumulative
Should the firm cease paying dividends, it cannot resume paying dividends on common shares until the preferred shareholders have all been paid their total dividends in arrears.
• Liquidity
Unlike bonds, many preferred shares are listed securities. This benefits retail investors seeking to sell small positions. If the shares are thinly traded, spreads could be an issue.
• Tax Treatment
In the US, preferred dividends are taxed at 15 per cent for most investors and 20 per cent for those in the top marginal bracket. Income from bonds is considered interest and is taxed at the holder’s tax rate, which can be as high as 39.6 per cent. UK taxation varies between 10 per cent to 42.5 per cent although the UK taxpayer receives a tax credit representing 10 per cent of the dividend amount.
Disadvantages
• Callable (or redeemable)
Like bonds, preferred shares often allow the issuer to redeem the shares after several years. This is a major disadvantage for investors seeking to lock in income in a declining rate environment.
• Growth
Preferred shareholders usually do not share in the capital appreciation potential of common shares. The higher level of income they are collecting is considered compensation.
• Voting
Common shareholders vote on directors and major shareholder issues. Preferred shareholders do not, except in extraordinary events.
Exceptions
• Convertibility
Some preferred shares include an option to exchange the shares for a specified amount of common shares. This allows the holder to participate in the value appreciation if a firm is doing well. Typically, once shareholders have exercised this right they cannot convert back into preferred shares. Convertible bonds offer similar benefits.
• Putable
Some preferred shares allow the holder to sell the shares back to the issuer at a set price within a specified time period.
• Poison pill protection
In the heyday of hostile takeovers, companies allowed classes of preferred shares to exercise voting rights as a form of ‘shark repellent’. Other features were sometimes built in as potential defences, yet in the UK its use is more restrictive.
Railroads issued the first preferred shares in the US during the 1830s. Today, banks and other financial institutions issue most preferred shares.
Quality
In the US, tier 1 capital shares are known as such if they satisfy regulatory requirements without subjecting common shareholders to dilution. In the UK, perpetual non-cumulative preference shares count as tier 1 capital. Cumulative shares are upper tier 2 capital. Dated preference shares with a maturity greater than five years are considered lower tier 2 capital.
When US billionaire investor Warren Buffet and US multinational firm Berkshire Hathaway want to invest in a company, the firm often creates specialised shares for the purpose. Establishing a $5bn (£2.9bn) stake in Bank of America in August 2011, he was issued 6 per cent cumulative perpetual preferred stock along with 700m warrants allowing him to buy BofA common shares at $7.14. With the BofA trading at $15.59 (on 21 November 2013) the warrants alone had a value of $5.88bn (£3.52bn).
Warren Buffet and Berkshire Hathaway made a similar investment in Goldman Sachs in 2008. Goldman exercised its right to redeem his preferred (with a 10 per cent premium) in 2011. He still retained the warrants afterwards. General Electric was another $3bn (£1.8bn) investment under similar circumstances.
Preferred stocks share characteristics with bonds, so they face risk similar to bonds in a rising interest rate environment: They should theoretically rise in value in a declining interest rate environment and fall in value when rates rise. Unlike bonds, most preferred shares do not have a maturity date, making them subject to wider price swings in a rising interest rate environment. In a declining rate environment the call date acts as a restraint on appreciation. Logically a firm would refinance the debt at a low rate when it had the opportunity.
Interest rate risk can be addressed to a degree with floating-rate preferred shares that reset a new rate periodically based on Libor or another specified index.
Several years ago closed-ended funds issued ‘auction-rate preferred’ securities, raising additional cash and leveraging the portfolio. Those shareholders received a higher rate of interest because of the leverage while owning a security that theoretically was liquid and reset at specific intervals. The market grew to $200bn (£135bn) in 2008, then became illiquid when securities could not be rolled over.
Trust-preferred securities are a hybrid vehicle where a company, usually a financial institution creates a trust and adds bonds, a form of subordinated debt. The trust issues trust-preferred securities which usually receive favourable tax treatment because they are paying dividends, not interest to the preferred shareholder.
Although not a preferred stock, sometimes common stock shares the non-voting feature. Some firms, as a takeover defense issue dual classes of common shares. The New York Stock Exchange allows the listing of dual class shares. Hong Kong and Singapore ban them. Class-A shares might be traditional with voting rights, class-B shares allow the holder to share in the appreciation (or depreciation) of the firm yet do not include the right to vote on directors or mergers. The founders might hold the voting shares and only sell non-voting shares to the public. One class might carry a disproportionately higher voting weight. When Google went public, class-A shares sold to the public carried one vote. Class-B shares, held by executives carried 10 votes. Facebook, LinkedIn, Nike and Timberland are other examples. Not all dual-class structures involve different voting rights. Some companies utilise the structure after mergers or for favourable tax purposes.
Terms can be deceiving. Preferred shares get preference regarding dividend income, yet they sacrifice significant benefits for the privilege. For clients seeking income the shares offer advantages although bonds and other fixed-income instruments should also be considered. For others seeking appreciation, common or ordinary shares are a better choice.
Bryce Sanders is president of Perceptive Business Solutions In New Hope, Pennsylvania, US. His book, Captivating the Wealthy Investor, is available on Amazon.com
Key points:
Preferred (or preference) shares bear the name for the advantages they bring the holder
Preferred shares may also come with significant disadvantages, such as a feature allowing the issuer to redeem the shares after several years
Preferred shares get preference regarding dividend income, yet they sacrifice significant benefits for the privilege
