Preferred shares are a relatively popular asset class, especially for Swedish, so called, dividend investors. This is due to the fact that most preferred shares pay a quarterly dividend unlike common stock, which usually pay an annual dividend. But how good are preferred shares as an asset class?
What are preferred shares?
First of all, all preferred shares are not created equal, and one must read all details for each company’s preferred share series in the prospectus for each series of preferred shares. However, they can be described in broad strokes.
Preferred shares are a part of the firms equity, with a preferred dividend. preferred shares usually have a nominal value for which the firm can repurchase the shares, usually at, or after, a specific date. Some preferred shares have a changing dividend or repurchase price depending on certain dates. For example the repurchase price may drop after some years, or the dividend may increase after such and such date. (Such details are the reason why each preferred share is its own, and why reading the documents are important before purchasing preferred shares)
Generally, preferred shares have the following traits:
- Predetermined repurchase price
- A date, after which they can be repurchased
- A fixed dividend, often fixed as a dollar amount
- They appear in the equity part of the balance sheet
Even though the name draws similarities to common shares, and the first point in the list above, preferred shares have more in common with bonds than common shares. This may sound strange, but let’s take a look at bonds.
What are Bonds?
Bonds are loans from the holder of the bond, to the company emitting the bond. For the holder of the bond, it is an asset. For the company, the bond is a part of the debt.
An interest paying bond has the following traits:
- An amount, called face value
- A date at which it will be repaid, the maturity date
- A coupon, an interest rate, stated as a percentage of the face value
- Appears in the debt part of the balance sheet
Bonds vs Preferred shares
Comparing preferred shares and bonds we see lots of similarities and one major difference.
- Both have a predetermined value (Repurchase Price, Face Value)
- Both have a date where that value can be exchanged for the paper (Repurchase Date, Maturity Date)
- Both have a predetermined yield (Dividend, Coupon)
- They appear in different parts of the balance sheet (Equity, Debt)
The similarities sum up to a fixed upside, or return. The difference lies in the downside, or risk.
How does that add up?
Given that an investor holds the preferred share until it is repurchased, the return is defined by the dividend plus the difference between the purchase price and the price at which the company repurchases the shares.
If an investor hold a bond until maturity, the return is the same. The interest rate, plus the difference between the purchase price and the face value.
However, the downside in bonds differ from the downside in preferred shares. This is due to the difference in debt versus equity.
The downside in both cases is 100%, in other words the preferred share or bond is worthless. However, should a company enter into bankruptcy, the company has to cover as much of its most senior debt, before any junior debt is paid out. If there are any funds left after the senior and junior debt has been repaid, the equity gets covered. Usually in a bankruptcy, there is not enough funds to cover all the debt, which means the owners (the holders of the company’s equity) gets nothing.
This leads to bonds having a lower risk, because they are debt in the balance sheet. Preferred shares carry the same risk as common stock, which is concealed with “preference”. The “preferred” part in preferred shares means that if a company can’t pay the dividend to its preferred shares, it can’t pay a regular dividend until the preferred shares dividend has been paid.
Bonds come with a capped upside, given that they are held until maturity. This comes with an associated level of risk. Higher risk leads to a larger coupon as a percentage of the face value.
Preferred shares come with the same capped upside, but have no protection if the company goes into bankruptcy. Holders of preferred shares take a risk which is very close to the risk in the common equity for the same company, but they don’t have the same potential upside.
Preferred shares come with the worst of both worlds, the capped upside of an obligation, and the 100% downside of common stock.
Are preferred shares a bad choice?
The simple answer is often yes, except for special cases often unattainable for retail investors.
Preferred shares can be very useful, if the problem of a capped upside is fixed. This can easily be remedied by adding another word to the name of the security: “convertible”.
If a preferred share is a “convertible preferred share”, which can be converted into a predetermined number of common shares, at some point in the future, the upside is no longer limited to the dividend. If the venture is very successful, the common stock gets a boost in value, but the preferred shares still get only the predetermined dividend. If the shares are convertible, the increased value of the common stock is also baked into the value of the convertible part of the convertible preferred shares.
Convertible preferred shares have the following advantages for the investor and the company emitting them:
- Unlimited upside
- Downside smaller than that of the common stock
- Increases the equity part of the balance sheet (lowers the debt-to-equity ratio)
The third point is something that makes convertible preferred shares better for the company than convertible bonds, which increases the debt burden on the company. Unfortunately there are no convertible preferred shares available for smaller investors as far as I know. These are not uncommonly used in venture capital deals and similar types of investments.
Preferred shares have an upside similar to bonds, and downside similar to common stocks. In other words, preferred shares are the worst of both worlds, because of the associated risk/reward. Convertible preferred shares are much better, but not available to smaller investors.
I hope you enjoyed my thoughts on preferred shares. Remember to do your own research before making any investment, which includes understanding the security you invest in.