Why investors want preferred shares? It’s no secret that many investors love to acquire preferred shares of a company as against common stock.
As the name suggests, preferred shares come with a wide variety of advantages, and holding them can be an incredibly lucrative venture.
While beneficial to purchasers, preferred shares are also a fantastic way of raising funds for a company that needs an injection of capital. In this article, we take a look at why investors want preferred shares over standard company stock.
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What Are Preferred Shares?
Preferred shares give investors more security and trust in terms of earning a more predictable return on their initial investment. While these shares often have different details depending on the company offering them, there are some aspects that are common.
In almost all cases, preferred stock gives shareholders an advantage over their common counterparts. That of offering a more reliable source of returns.
Owning preferred shares in a company makes you more of a priority when compared to those with common stock. This priority is demonstrated in the form of both dividend payments and asset recuperation, should the issuer face bankruptcy.
Different Types Of Preferred Stock
There are a few different types of preferred stock, which we will mention here. We’ve touched on most of the points here and will expand further.
- Preferred Shares – Companies aim general preferred shares at those looking to get paid regular dividends by a company. They also have rights to more company assets in the event of liquidation.
- Callable Shares – This type of stock gives companies the option to purchase your shares at a set date at a prearranged price. While still profitable, this is often seen as a negative. That’s because the company can buy back shares if their value exceeds the already established price.
- Convertible Shares – This variation ensures that your preferred shares are converted whenever you wish. Investors see this only as an advantage.
- Cumulative Shares – Cumulative shares mean that the company pays the value of dividends for preferred holders before regular payments are made to common shareholders. It also ensures that if they miss a dividend payment, the owed amount will be added to your next installment.
- Participatory Shares – With this type of preferred share, you will essentially lock in a dividend rate. Its the company’s obligation to ensure payment. In addition to this, you will be eligible for extra dividends if the issuing company meets certain financial goals.
In this article, we will be looking at the benefits of all types of preferred shares, while also briefly touching on the disadvantages too. We’ll also explain why investors want preferred shares.
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The Benefits Of Preferred Shares
The privileges associated with preferred stock are vast and should carefully be considered by potential investors and issuing companies. These advantages include, but are not limited to the following.
Better Dividend Payments
Being a preferred stockholder entitles you to regular dividend payments, which are typically higher than those paid through common stocks and bonds.
These payments are also made on a more regular basis, offering further monetary stability. If the company wants to provide additional dividends, preferred holders are made a priority.
The company fixes dividend payments in many cases. The dividend payment for preferred holders might pause during this time. But, it will be the company’s obligation to pay preferred shareholders before resuming dividends to common holders.
While not completely guaranteed, the business will seek to pay preferred holders their dividends when possible.
Safety In Case Of Liquidation
While purchasing shares in a company will always come with associated risks, preferred stock can help to minimize the dangers.
If a business goes bankrupt during the time you are a preferred shareholder, you become one of the earliest parties eligible to claim assets. However, it is important to note that bondholders rank higher in this list of distributions.
The Right To Convert Your Stock
Another potentially lucrative aspect of owning preferred shares is that you can convert to common stock at your discretion. The obvious advantage here is that you can acquire common stock should the price climb.
You can then sell this common stock for an immediate return on your initial investment, should you see a large enough rise. Keep in mind that if you do opt to trade your preferred stock, you will lose all of the associated perks mentioned previously.
You also cannot trade your common stock back to preferred stock, should you wish to do so in the future. And, that’s one of the reasons why investors want preferred shares.
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Are There Drawbacks To Preferred Shares?
Preferred shares certainly have an edge over common alternatives, but there are a few drawbacks to keep in mind:
The issuer can choose to redeem their shares back at a predetermined date, which stands at 5 years in many cases. The price you sell back at will be determined upon purchase. So keeping this date in mind is essential to protect your investment.
Selling before this expiration date is not always the most profitable route to take, however, as the set call price could be significantly more than the current value.
The main downside to a call-back price is that your investment is essentially capped there. If it goes above the stated price, the company will almost definitely want to purchase them back. Making this figure as high as possible is the sole aim of many investors.
The current rate of interest plays a huge role in the value of preferred shares. When interest rates decline, the value of your share will increase and vice versa.
Smart investors keep this in mind and many seek to invest like this when interest rates are already relatively low.
This is one of the only areas in which common stocks have an advantage over their preferred counterpart. Usually, holders get no voting power within the business, whereas common holders get a vote in correlation to the ownership level.
This is most prevalent when a company decides to elect a new board or governing committee.
As a rule of thumb, preferred shares are safer than purchasing common stock but have slightly less policies in place than bonds.
While bonds are considered safer, particularly to hedge against interest rates, preferred stock comes with a whole host of other monetary-based incentives.
It’s this high-yielding format that is a large reason why investors want preferred shares.
Preferred Shares Vs. Common Stocks
The underlying difference between the two types of stock comes down to both voting and dividend yield. This often substantial monetary gain is usually the reason why investors want preferred shares.
When making the choice between the two, the main question investors ask themself is whether or not the increased yield makes up for the removal of voting rights.
Commonly, if the investor is happy with how the issuing company is run, the answer is often yes. However, in rare cases, the voting power of shareholders can have a huge impact on the success of a company.
In the latter scenario, a common stock might be viewed as a more appealing option.
Who Buys Preferred Shares?
Investors that purchase preferred shares are usually looking for a relatively safe investment that comes alongside a high, regularly paid yield.
Besides a steady income from these shares, they can stay in place indefinitely, as long as the company doesn’t opt to recall.
If the price of a share remains below the call price, you are likely able to hold your stock for a lengthy period of time, generating a better ROI than traditional alternatives.
Those who purchase preferred stocks are likely looking for a longer-term investment, reaping the rewards of dividends on a regular basis. Obviously, the call price has to also be taken into account when deciding on the longevity of an investment involving preferred shares.
Another investor of preferred shares is institutions, which gain significant tax benefits from doing so. They gain these benefits as they are not investing personally, so a much lower band of tax is applied to their purchase.
However, these tax benefits are not just applied to preferred shares, but the majority of investments as a whole.
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Why Companies Provide Preferred Shares To Investors
The main reason behind institutions offering preferred shares to investors is that it allows them to raise more capital without too much risk. It helps to keep their debt-equity ratio low, which attracts investors to purchase other variations of stock. Other reasons for companies offering preferred shares include:
Reduction Or Elimination Of Bonds
Often, companies don’t like offering bonds to investors. The main reason for this is that it can significantly harm cash flow, due to tough repayment clauses that must be followed.
A large percentage of bonds being offered can discourage future investments, as the chance of bankruptcy is heightened. The fewer bonds that are offered, the less debt a business is likely to accrue.
As previously mentioned, preferred shares can be callable. This means the company can purchase back their stocks at an agreed price. Usually, after this is done, the shares can be canceled.
Less Voting Rights
As preferred shares usually come with no voting rights, they can be offered without the need to worry about a hostile takeover. The owners can regain a larger control over daily operations, allowing them to run the business as they intend.
Issuers can create favorable terms for their preferred shares, which the investor will have to agree with before making a purchase. You would have to provide the practical incentives for why investors want preferred shares.
When you purchase preferred stock, the company is obligated to pay you a fixed rate dividend. It only makes you a priority to receive them. There is nothing in place to force the issuer into paying your due dividend.
If a company doesn’t have the required funds, they can often simply defer this payment without any penalty.
Preferred shares are often a comfortable way for an issuer to raise funds. They can do this without having to worry about disrupting key areas of the business or generating a large field of creditors.
In particular, the finance sector is known to be the most popular industry when it comes to offering preferential shares.
Example Of A Preferred Share
An example would be a company offering 10,000 shares at a value of $10,000 each. They offer 1,000 of these shares as preferred variations, with the remaining 9,000 as common stock.
Preferred stock for the said company may offer 8%, paid quarterly, while common stock yields 5% which the company pays on a yearly basis.
If you bought 1 preferred stock, you would stand to make $800 a year, which you would receive in payments of $200 approximately every 3 months.
With a single common stock, you would earn $500 in dividends, which the company pays every 12 months. By using this example, you can see that a preferred stock yields $300 more per annum.
There is also the added benefit of a more regular payment schedule, with 4 installments yearly instead of one.
Hopefully, this article clears up why investors want preferred shares in a company. They are essentially a hybrid of common stock and bonds, offering a variety of benefits from each.
The main advantage is the high yield, which is the most attractive aspect of the investment to many. Another key benefit is the priority of receiving assets should the company go into liquidation.
Before making an investment with preferred shares, it’s essential to weigh up the risks. This comes in the form of increasing interest rates, low call-back price agreements, and giving up your rights to vote for major changes in the issuing company.
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