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The stock market offers numerous exciting opportunities with distinct risk and reward ratios. Preference shares stand out in the investing landscape as an appealing option for seasoned investors and novices seeking consistent returns against a lower risk comparatively in the stock market.
In this article, let’s understand preference shares, their characteristics, pros and cons, and how market forces impact them.
What are preference shares?
Preference shares, as the name suggests, offer certain preferences and privileges to investors. Preference shareholders are entitled to receive the dividends announced by the company before common shareholders. Here are some of the unique characteristics of preference shares:
- Hybrid investment
They offer fixed dividend payments like debt securities and carry ownership characteristics, bringing them close to equity investments.
- Fixed dividend rate
They offer a predetermined dividend rate, which adds consistency to investment portfolios unlike common shareholders, whose distributions may change depending on the company’s financial success.
- Liquidation preference
If a company winds up, preference shareholders are on the priority list over common shareholders in the asset distribution among creditors. This feature of preference shares safeguards investors’ allocated funds.
- Restricted or no voting rights
In exchange for their preferential treatment in dividend payments and during liquidation, investors have to give up their voting rights.
Types of preference shares
Following are the types of preferences shares, based on varied aspects:
- Based on dividends
Cumulative – Accumulated unpaid dividends are settled before dividend distribution to equity shareholders.
Non-cumulative – Unpaid dividends are not accumulated and paid.
- Based on redeemability
Redeemable – Shares can be redeemed after the expiry of a predetermined period.
Irredeemable – Shares cannot be redeemed until liquidation.
- Based on convertibility
Convertible – Preference shares will be converted to equity after a specific date.
Non-convertible – Shares will remain preferential until liquidation.
- Based on participation
Participating – Allows shareholders to participate in profits and receive over and above the fixed dividend.
Non-participating – Shares are entitled to a fixed dividend only.
Reasons behind issuing preference shares
- Controlled debt-to-equity ratio: Issuing preference shares is one of the preferred ways for companies to raise fresh capital while limiting their debt-to-equity ratio. Companies want to show reduced debt on their balance sheets as it indicates high credibility to shareholders and analysts.
- A higher degree of control over corporate decisions: Companies often opt to issue preference shares as a strategic means to maintain a high degree of control over business and voting rights to vital corporate decisions. It safeguards the company’s strategic vision.
- Avoiding profit distribution: When companies issue common shares, they need to pay dividends according to their performance. Exceptional company performance can lead to higher dividend payments. On the other hand, generally, preference shareholders receive dividends at a fixed rate.
Differences between preference and common shares
- Rights: Common shares typically grant voting rights to shareholders to participate in key decisions, unlike preference shares.
- Earnings: Unlike fixed dividends in preference shares, dividends to common shareholders may vary based on the availability of the company’s profits.
- Risk: Common shareholders need a higher risk tolerance than preference shareholders.
- Residual claims: In an unfortunate event of liquidation, common shareholders can claim the company’s assets only after payments to creditors and preference shareholders.
Advantages of investing in preference shares
The key advantages of preference shares are enumerated below:
- Stable income stream: Investors who rely on their investments to generate a consistent income stream, like retirees, are often drawn to preferential issues due to fixed rates of dividends. The predictability of returns on preference shares makes them more appealing to investors.
- Asset protection: Preferential issues can safeguard your investment and a preferential claim over the company assets.
- Resilient portfolios: Preference shares can help investors to diversify their investment portfolios. It can bring a balance between income and growth, allowing investors to create a more resilient portfolio.
- Low risk: As preferential issues are offered with the feature of prioritisation at the time of liquidation, there is low risk for investors.
Disadvantages of investing in preference shares
- Potential for lower returns: When compared to common shares, preferential issues have the potential to offer lower returns. Even if the company performs well and makes significant profits, there will be the same rate of dividends offered to preferential shareholders.
- Vulnerability to changes in interest rates: Changes in interest rates can affect the attractiveness of preference shares. As interest rates surge, fixed-income products or debt securities may provide higher yields. It can make the fixed dividends of preferential issues less appealing relatively.
Thus, strategic investing in preference shares can offer a balanced blend of security and return potential, making them an intriguing proposition for most individuals interested in the stock market.
Raising capital through debt requires companies to take loans for interest. This may affect the balance sheet negatively. Raising capital through equity requires them to compromise on their ownership and control. Preference shares offer the best of both worlds, by offering shares without companies having to give up their control on management or pay heavy interest.
This decision purely depends on the individual investor’s financial goals and risk exposure. If you are risk averse and want a steady income, but also want the stock market exposure, preference stocks are for you. But, if you are looking for high-risk-high-return investments, you may consider common stocks.
Preference stocks rank number two at the time of liquidation and periodic payments. Debenture and bondholders are given the first priority in interest payments and settlement during liquidation. Preference shareholders come after them, but they stand before equity shareholders.
Similar to buying common stocks, preference shares can be bought in an Initial Public Offering (IPO) or a Follow-on Public Offering (FPO) or can also be traded on the stock exchange. Preference stocks also require investors to own a demat and trading account with a brokerage firm.