What Are Preferred Shares and Why Are They Preferred?

Preferred shares, often known as preferred stock, represent a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Investors who hold preferred shares generally receive a fixed dividend, which is paid out before dividends on common shares. In the event of liquidation, preferred shareholders also have a higher priority in recovering their investment compared to common shareholders.

Key Features of Preferred Shares

1. Fixed Dividends: One of the most significant features of preferred shares is the fixed dividend rate. Unlike common shares, which have variable dividends that can fluctuate based on the company's profitability, preferred shares come with a predetermined dividend. This provides a more stable income stream for investors, making them a popular choice for those seeking consistent returns.

2. Priority in Dividends: Preferred shareholders have a higher claim on dividends compared to common shareholders. Dividends on preferred shares must be paid out before any dividends are distributed to common shareholders. This priority makes preferred shares more attractive to income-focused investors.

3. Liquidation Preference: In the event of a company's liquidation, preferred shareholders have a superior claim over common shareholders when it comes to asset distribution. This means they are more likely to recover some of their investment if the company goes bankrupt.

4. Convertibility: Some preferred shares come with a convertibility feature, allowing investors to convert their preferred shares into a specified number of common shares. This feature can be advantageous if the company’s common stock performs well, providing potential for capital gains.

5. Callable: Preferred shares may also be callable, meaning the issuing company can repurchase them at a predetermined price after a certain date. This feature offers the company flexibility but can limit the potential upside for investors.

6. Cumulative Dividends: Many preferred shares include a cumulative dividend feature, which means if the company skips or defers a dividend payment, it must pay the missed dividends before any common dividends can be issued. This adds an extra layer of security for investors.

Why Are Preferred Shares Preferred?

1. Stable Income Stream: Preferred shares provide a predictable and stable income through fixed dividends. This stability is particularly attractive to income-focused investors, such as retirees, who need regular income streams to support their living expenses.

2. Lower Risk: The fixed dividend and higher claim in liquidation reduce the investment risk compared to common shares. Investors who prioritize capital preservation might find preferred shares a safer option.

3. Investment Diversification: Preferred shares offer a way to diversify an investment portfolio. They can provide a balance between the higher potential returns of common stocks and the fixed income of bonds, making them a versatile investment choice.

4. Tax Advantages: In some jurisdictions, dividends from preferred shares might enjoy favorable tax treatment compared to interest income from bonds. This can enhance the after-tax return for investors.

5. Potential for Appreciation: While preferred shares are generally considered income-generating investments, those with convertibility features offer potential for capital appreciation if the company’s common stock performs well. This adds a growth element to the investment.

Comparing Preferred Shares with Common Shares and Bonds

• Preferred Shares vs. Common Shares: Preferred shares are typically less volatile than common shares due to their fixed dividends and priority in liquidation. However, common shares offer greater potential for capital appreciation and voting rights, which preferred shares generally do not provide.

• Preferred Shares vs. Bonds: Bonds offer a fixed interest payment and are generally considered safer than preferred shares in terms of priority in liquidation. However, bonds do not usually offer the potential for capital appreciation or convertibility features that preferred shares might offer.

Conclusion: The Appeal of Preferred Shares

Preferred shares hold a distinct place in the investment landscape due to their unique combination of fixed income, lower risk, and potential for capital appreciation. They cater to investors seeking stability and reliable income while also offering some growth potential through features like convertibility. Their preference over common shares and bonds depends on individual investment goals and risk tolerance. Understanding these aspects can help investors make informed decisions about including preferred shares in their investment portfolios.