Business, Legal & Accounting Glossary
n. a class of shares of stock in a corporation which gives the holders priority in payment of dividends (and distribution of assets in case of dissolution of the corporation) over owners of “common” stock at a fixed rate. While the assurance of first chance at profits is a psychological and real benefit, preferred stock shareholders do not participate in higher dividends if the corporation makes large profits, and usually cannot vote for directors.
Preferred stock, also known as preference shares, is a special class of shares issued by joint-stock companies. Preferred stock is a hybrid financial instrument that combines the properties of a debt instrument and equity. As a general rule, preferreds, as they are commonly referred to in markets, are ranked above ordinary shares but below bonds inasmuch it concerns their claim to share of the assets of a corporation.
Normally, preferred stock does not have voting rights but enjoys priority over common stock, or ordinary shares in terms of dividend distribution and upon liquidation. The terms under which a company offers preferred stock is a subject matter of “Certificate of Designations.”
Preferred stock is rated by credit agencies just as bonds are. However, ratings of preference shares are usually lower than bonds because interest (dividend in case of preferreds) is not guaranteed.
Being a special class of equity, preferred stock has features that ordinary shares do not have. Preference shares are called as such as they have preference over common stock in dividend distribution and right to assets when a company is liquidated. Preferred stock can be converted into common stock, can be called back by the company and does not carry any voting rights.
Generally speaking, the preference is about payment of dividends. The terms of the issue of preference shares include the rate of dividend. It is not a guarantee that dividend will be paid but in case dividend is announced, the company must first pay it to holders of preferred stock at the specified rate before paying a dividend on common stock.
The terms of issue also states whether a preferred stock is cumulative or non-cumulative. In case of cumulative preferred stock, if the company fails to pay a dividend at the specified rate, it has to make up for the shortfall in subsequent years. In a cumulate option, dividends keep accumulating quarterly, semi-annually or yearly as the case may be. Non-cumulative preferred stock does not have this privilege. If a dividend is not paid in time is lost forever.
Non-cumulative preferred stock is common in TRuPS (trust-preferred stock) and bank preferred stock since as under the rules set by Bank for International Settlements, for inclusion in Tier 1 capital, a preferred stock must be non-cumulative.
Besides these features, preferred stock may have certain other features as well. These include but not limited to:
The list is no comprehensive in any way. Issuance of preference shares is similar to a legal contract and may include any conceivable feature and condition as long as it is within the ambit of the law. In the USA, nearly all preferred stock carries a call provision, which gives the company a limited right to repurchase preferred stock.
Issuing shares, including preference shares, is an attractive form of financing for corporations. In contrast to traditional means of financing, dividend payments, in most cases, can be deferred by going into arrears. A debt, however, must be serviced as per the terms of the loan agreement and missed payments put the company in default.
From time to time, companies use preference shares as a means to block hostile takeovers. This is done by issuing preferred shares with typical shareholder rights plans, which are primarily features such as forced exchange and conversion that can be exercised in the event of a change in control. Some companies include a clause in its articles of association that authorizes the board of directors to issue preferred stock on whatever terms they deem fit. The board uses the authorization to issue preferred stock with extremely high liquidation value or enormous voting rights, provisions that can be used to prevent hostile takeovers. Known as a poison pill in market terminology, these are blank checks used mostly as a defence against a takeover.
Another usage relates to times when a company goes bankrupt and there is not much money left for distribution to shareholders. Each series of preferred stock must necessarily be senior or equal or junior in priority to other series of preferred stock already issued by the company. When the preference issue is offered for subscription for the first time, the offer document may stipulate that any subsequent preference issue will only have lower seniority. In that case, the senior preferred stock gets paid first.
Preferred stock is common among all types of companies including private, public or joint sector companies particularly with the purpose of distinguishing between control and the economic interest of companies. Issuance of publicly traded preferred stock may be discouraged or encouraged by governments or stock exchanges. For example, many countries encourage banks to issue preferred stock as a source of their Tier 1 Capital while some stock exchanges in some countries impose a condition on listed companies that they have only one class of stock.
A company may issue more than one class of preferred stock whenever it chooses to raise funds through this method. Each issue of preferred stock may be classified as Series A, B or C with each having separate rights.
In the USA, there are two types of preferred stock; straight and convertible. Straight preferred stock is usually perpetual in nature and pays a stipulated rate of dividend to the holder. These may, in certain cases, may be subject to redemption by the company under certain conditions. Convertible preferred stock, in conjunction with the features of straight preferred stock, provides for conversion to the common stock of the company or to that of a subsidiary or affiliated company. There may be concomitant provisions in regard to the fate of conversion, price and number of shares per preference share.
US corporations investing in preferred stock enjoy certain income tax advantages that are not available to individuals.
It is often argued that being a hybrid instrument, a cross between equity and a bond, straight preferred stock has the disadvantages of both without the advantages of either. It is similar to a bond and as such does not get the benefits associated with the growth of the company and when profits increase. It neither gets additional dividend nor enjoys price appreciation the way the holders of common stock do. Bonds are more secured as they must necessarily be redeemed on the predetermined future date. Similar to common stock, the straight preferred stock is less secure but does not provide the benefit of getting additional dividends and price appreciation.
However, preferred stock provides the issuer the advantage that the preferred stock gets better credit rating than straight debt by virtue of its perpetuity. Moreover, certain types of preferred stock qualify for Tier 1 capital and can be used by financial institutions for raising Tier 1 credit.
If a buyer paid par value or $100 for a typical straight preferred stock, the investment would give a yield of just over 6%. If at the same time, in a few years’ time, 10-year Treasuries were to yield 13+% on maturity, just the way they did in 1981, the preferreds would yield at least 13%. This would effectively result in the market price of the preferred falling down to $46, a loss to 54% to the shareholder. The difference to be highlighted between straight preferred stock and Treasuries or any other investment-grade bond is that the bond value will move gradually towards par value as the maturity date approaches while the value of the preferred stock will tend to hover at $40 levels for quite some time as it does not have a fixed maturity.
The advantages of preferred stock, however, lie in the fact they provide higher yields, tax advantage that is presently 2% more than 10-year Treasuries, are senior to common stock when it comes to bankruptcy and dividends are taxable at a maximum of 15% instead of normal income tax rates that apply to bond interest.
A significant portion of the Canadian equity market comprises of preference shares. Preference shares to the tune of as much as CAD 5 billion dollars were issued and subscribed in 2005.
In Canada, perpetual preference shares qualify for Tier 1 capital. As such, most issuers of preference shares in Canada are financial institutions that need to raise Tier 1 capital. Split share corporations, are another class of issuers of preferred stock in Canada. A split share corporation exists for a defined period of time for the purpose of transforming risk and investment return of a basket of shares of conventional dividend-paying corporations into the risk and return of two or more classes of publicly traded shares in the split share corporation.
Preferred stock is also issued by private companies to take advantage of Canadian tax laws. Issuance of preferred stock allows businesses to freeze an estate account. Businesses can transfer common shares in exchange for fixed-value preferred stock so that future gains in business value accrue to other persons such as a family trust.
Canadian investors who prefer to invest in preferred stock are those who desire to include fixed income instruments in a portfolio that is otherwise taxable. Dividend income is given preferential treatment over interest income while calculating income tax. In many cases, this results in major gains by virtue of better after-tax returns as compared to bonds and other interest-bearing investment vehicles.
In Germany, preferred shares of a company may be as much as fifty per cent of the total number of shares. German law also allows for the conversion of preferred shares into ordinary shares provided the proposal is approved by the majority of the shareholders. If approved, the law requires consensus with owners of preferred stock for conversion of their holdings. For the purpose of consensus, a one-time premium is usually offered to preference shareholders. Companies may want to do so for a variety of financial reasons including influencing their ranking in a particular index. Industry-specific stock indices normally do not take into account preferred stock for determining daily traded volumes. Companies with low traded volumes in common stock do not qualify for listing in some indices.
Non-cumulative perpetual preference shares qualify for inclusion in Tier 1 capital. On the other hand, cumulative perpetual preferred stock may be part of Upper Tier 2 capital. Preferred stock with original maturity of five years or more qualify for inclusion in Lower Tier 2 capital.
In the USA, it is usually financial institutions, public utilities and REITs (real estate investment trusts) that issue preference shares. The major reason for this is that at corporate level, dividend paid on preferred stock is not tax-deductible in contrast to expense on interest. This translates into a situation where the cost of raising capital by way of preferred stock is effectively 35% more than raising equal amount of capital by way of debt at the same rate. The market, however, found a way out with the development of an innovative financial instrument known as TRuPS or trust preferred security. TRuPs are basically debt instruments that have properties similar to preference shares. However, with the passing of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, the route of raising Tier 1 capital by bank holding companies through trust preferred securities will be phased out. Whatever trust preferred securities that exist shall have to be gradually terminated completely by 2015.
With dividend tax, qualified at 15% as compared to the top tax slab of 35% for interest, the after-tax income for $1 dividend income and $1.30 of interest income comes to approximately the same amount.
Due to reasons such as these the overall market for preferred stock is substantially less than that for equities and debt instruments like bonds. In early 2008, the market for preference shares was approximately US$ 100 billion while that of equities was US$ 9.5 trillion and US$ 4.0 trillion for bonds.
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This glossary post was last updated: 30th April, 2020 | 6 Views.