Preference Shares

What do you mean by preference shares

Preference shares, also referred to as preferred stock, are a unique category of shares that offer investors a blend of fixed-income features and equity characteristics. Unlike common equity shares, preference shares grant shareholders the right to receive dividends before any dividends are paid to equity shareholders. In case the company faces liquidation, preference shareholders also have a prior claim on the company’s assets. 

However, they typically do not enjoy voting rights in the company’s decision-making processes. Preference shares are often considered a hybrid financial instrument, combining the benefits of debt-like steady income with some elements of equity ownership.
 

What are the main types of Preference Shares?

Companies may issue different types of preference shares to meet various investor needs. These include:

• Cumulative Preference Shares: Allow accumulation of unpaid dividends, which are paid in subsequent profitable years.
• Non-Cumulative Preference Shares: Dividends are only paid from profits of the current year; missed payments are not recovered.
• Participating Preference Shares: Shareholders may receive additional dividends if the company performs well and declares surplus profits.
• Non-Participating Preference Shares: Entitled only to fixed dividends, with no claim on additional profits.
• Redeemable Preference Shares: Can be bought back by the company at a predetermined time or condition.
• Irredeemable Preference Shares: Can only be redeemed during liquidation or winding up of the company.
• Convertible Preference Shares: Can be converted into equity shares after a specific period at a fixed rate.
• Non-Convertible Preference Shares: Cannot be converted into equity shares; remain as fixed income instruments.
• Adjustable Rate Preference Shares: Dividend rate fluctuates based on prevailing market interest rates.
• Callable Preference Shares: The company holds the right to buy back these shares at a pre-agreed price and date.

Reasons to Invest in Preference Shares

Investors choose preference shares for several reasons, particularly for their income and safety features. Key advantages include:

• Fixed Dividend Income: Preference shares provide a steady income stream through predetermined dividend payouts.
• Lower Volatility: These shares experience less price fluctuation compared to equity shares, making them suitable for conservative investors.
• Priority in Payments: In the event of liquidation, preference shareholders are paid before equity shareholders.
• Convertible Options: Convertible preference shares offer the flexibility to convert into equity and benefit from capital gains.
• Tax Efficiency: In some cases, dividends may receive favourable tax treatment compared to interest income.
• Capital Protection: These shares offer more security, particularly in economic downturns or market uncertainty.
   

Features of Preference Shares

1.    Preference shares have a preferential right or claim over the company’s assets or capital.
2.    The shareholders receive a fixed, pre-determined dividend from the company and have priority over equity dividends.
3.    Preference shareholders are paid before equity shareholders when the company is winding up.
4.    Preference shares can be redeemed from the company.
5.    They can be converted to equity shares.
6.    Some preference shares are eligible to receive cumulative arrears of dividends if any.
7.    Preference shares can be invested for medium to long-term periods as the risk associated with them is low compared to equity shares.

The share market, especially equity shares, is infamous for being volatile. The finance world is filled with stories of people who invested in equity shares losing their hard-earned money. In many instances, they are deprived of their life savings. By choosing preference shares, many investors can rest assured that their money is safe. Not only is it protected from the volatility that equity experiences, but they are also assured of getting the investment in the worst case when the company dissolves.   
 

How to Choose the Right Preference Share

Selecting suitable preference shares requires a thorough evaluation of both the instrument and the issuing company. Investors should consider the following factors:

• Dividend Terms: Determine whether the shares offer cumulative, non-cumulative, fixed, or adjustable dividends.
• Convertibility: Assess whether conversion to equity aligns with your long-term investment goals.
• Redemption Features: Understand the maturity timeline and conditions for redemption or buy-back.
• Issuer’s Financial Health: Evaluate the financial position and track record of the issuing company.
• Liquidity: Consider if the preference shares are listed and actively traded for ease of exit.
• Participation Rights: Participating shares offer added benefits during profitable years.
• Investment Horizon: Align your investment in preference shares with your income expectations and risk profile.
• Tax Considerations: Review the tax treatment of dividend income in your jurisdiction.
   

Difference Between Preference Shares and Equity Shares

While both preference and equity shares represent ownership in a company, they differ significantly in structure and benefits. Key distinctions include:

Dividend Policy: Preference shares offer fixed dividends, while equity dividends are variable and performance-based.
Priority in Claims: Preference shareholders have a prior claim on dividends and assets over equity shareholders.
Voting Rights: Equity shareholders hold voting rights; preference shareholders usually do not.
Return Potential: Equity shares offer higher potential for capital appreciation; preference shares offer more stable but limited returns.
Risk Profile: Equity shares are riskier and more volatile; preference shares are considered safer.
Liquidity: Equity shares are more actively traded and hence more liquid.
Ownership Influence: Equity holders can influence corporate decisions; preference shareholders cannot.
Conversion Rights: Only some preference shares can be converted to equity; equity shares are non-convertible.

Advantage of Preference Share

Preference shares offer several advantages:

• Fixed Dividends: Preference shareholders receive a fixed dividend, often higher than common equity dividends, providing steady income.
• Priority in Payments: In case of company liquidation, preference shareholders have priority over common shareholders in receiving payments.
• Lower Risk: Compared to equity shares, preference shares are less volatile and carry lower risk, making them suitable for conservative investors.
• Convertible Options: Some preference shares can be converted into equity shares, allowing investors to benefit from potential capital appreciation.
• Cumulative Dividends: If dividends are missed, they accumulate and must be paid before any dividends to equity shareholders.
• Callable Feature: Companies can buy back preference shares, providing flexibility in managing capital.

Disadvantage of Preference Shares

Preference shares, while offering fixed dividends and priority over equity shares in terms of payouts, come with several disadvantages for investors:

• Limited Capital Appreciation: Preference shareholders generally do not benefit from the significant capital gains that equity shareholders might enjoy if the company performs exceptionally well. The returns are mostly limited to fixed dividend payments, making them less attractive for growth-oriented investors.
• Lack of Voting Rights: Preference shareholders typically do not have voting rights in the company. This limits their ability to influence key decisions or participate in important corporate matters like mergers, acquisitions, or management changes.
• Dividend Non-Guarantee: Although preference shares offer fixed dividends, these are not guaranteed. If the company faces financial difficulties, it may delay or skip dividend payments altogether, especially in the case of non-cumulative preference shares.
• Lower Liquidity: Preference shares are generally less liquid compared to equity shares. The market for trading preference shares is smaller, which can make it challenging for investors to exit their positions quickly or at a favorable price.
• Callable Nature: Many preference shares are callable, meaning the issuing company can repurchase them at a predetermined price. This can limit the investor’s potential returns if the shares are called when interest rates are lower.

These factors make preference shares a less favorable choice for some investors, especially those seeking growth, control, or liquidity.

Conclusion

The share market, especially equity shares, is infamous for being volatile. The finance world is filled with stories of people who invested in equity shares losing their hard-earned money. In many instances, they are deprived of their life savings. By choosing preference shares, many investors can rest assured that their money is safe. Not only is it protected from the volatility that equity experiences, but they are also assured of getting the investment in the worst case when the company dissolves.