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Preference shares

Preference shares

A preference share is like a halfway house between an ordinary share and a corporate bond.

If that sounds like something from Alice in Wonderland, you’re not far wrong.

The risk versus return profile of preference shares can be hard to work out due to their hybrid nature.

They often seem to deliver just a little extra yield over corporate bonds, but for a much greater risk.

But occasionally such shares  (known as ‘preferred stock’ in the US) can offer attractive opportunities for investors who do their homework.

What are preference shares?

Like shares and corporate bonds, preference shares are a way in which listed companies raise money.

They differ in terms of the rules about how owners must be paid an income, and what happens if they’re not.

First, the good stuff.

  • Preference shares are listed on the stock market, like ordinary shares.
  • Holders receive a fixed dividend, just like bondholders.
  • The running yield you get depends on the price you pay in the open market.
  • Their dividends must be paid before any ordinary dividends can be paid.

This fixed income can seem a very attractive alternative to the fluctuating dividend payments from ordinary shares.

Remember though that because your income is fixed:

  • The preference share price will fluctuate with interest rates and inflation.
  • Over the years the dividend in real terms will be eroded by inflation, just as with all fixed income securities, which will severely cap long-term returns.

This is very different situation to ordinary share dividends, which in aggregate tend to go up over time – which means that ordinary share prices can continue to grow indefinitely.

The other risks of owning preference shares

As I said, preference shares are riskier than bonds.

If bondholders aren’t paid their interest, they can bankrupt the company. The same is not true of preference shares – companies can skip such dividend payments, just as with ordinary dividends.

Most preference shares are cumulative. In theory this means that if holders aren’t paid their dividend in some particular year, then they must be paid in full if and when the company is subsequently able to.

  • Those are important ifs – if the company goes bankrupt, you’ll never get your lost income.

In such circumstances, preference shares rank ahead of ordinary shares in terms of the company’s capital structure – but behind bondholders.

In practice, when a company goes bust – and the ordinary shares become worthless – then even bondholders seldom get all their money back.

In such circumstances, preference shareholders get nothing.

Tax treatment

In the UK, preference share dividends are treated tax-wise the same way as ordinary dividends.

That means lower-rate tax payers have no more tax to pay on their income, while higher-rate taxpayers are effectively taxed at 25%.

The bottom line

In my view, the extra security of having to be paid a dividend before ordinary shareholders – and the cumulative payments if you’re not paid – are attractive benefits of preference shares. But I think the ability to claim company assets is pretty useless in practice.

Preference shares are certainly unusual instruments, and tend to be issued in unusual times. Warren Buffett bought some in Goldman Sachs during the banking crisis, for instance.

During the same period, investors who bet that UK banks wouldn’t go bust by buying their preference shares saw their investment double or triple in just a few months. Some locked in a yield on the purchase price of as much as 30%!

But usually investing in these special shares is more about getting a slightly better income, in return for forgoing the chance of equity-like gains.

Further reading

  • Fixed Income Investments – This is a site run by a private investor which at the time of writing (May 2010) is probably the most up-to-date source of data out there for preference share investors.

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{ 6 comments… add one }
  • 1 David May 18, 2010, 4:36 pm

    Have you thought about investing in Tier 1 securities called hybrids?

    I read an article in MoneyWeek last year and have been meaning to buy some ever since:

    http://www.moneyweek.com/investments/bonds-higher-bank-savings-interest-rate-449p08.aspx
    .-= David on: HM Revenue & Customs Tax Refund Alert Notification – Beware Scam! =-.

  • 2 Niklas Smith May 18, 2010, 7:24 pm

    Interestingly, preference shares used to be the method of choice for raising capital in nineteenth-century Britain. Companies wanted to create a security that would be as similar as possible to the then-standard form of government debt, consols (perpetual bonds).

    Do you have any idea why governments moved from issuing perpetual securities to bonds? Or were the British the odd ones out in doing that? From a national debt management perspective consols have many attractions, not least that you don’t need to refinance them! But I suppose in an era of inflation people prefer to have a term for their investment.

  • 3 The Investor May 18, 2010, 9:00 pm

    @Niklas – Interesting! I’m afraid I don’t have any further light to shed on it… although given the dire investment that the likes of the undated War Loan gilt at 3.5% proved for those who bought and held at issue, perhaps it’s not surprising! (Though of course they weren’t to know about the inflation that was to come…)

  • 4 The Investor May 18, 2010, 9:12 pm

    Hi David – Yes, I have had a quick look at all sorts of strange debt instruments in the past few months. In particular I was looking at some that step up their coupons payable if they’re not called in a few years time, as a play on interest rate expectations.

    But to be honest I’m very wary of investing much in any of this stuff, since the Government and the banks lawyers seem to an extent to be making up the rules as they go along – understandably perhaps given the unexpected failures we’ve seen in recent years (e.g. Northern Rock and Bradford & Bingley). Some of the spreads are horrid, too. Finally, in my investment in Natwest preference shares I’m placing considerable weight (perhaps wrongly) in Natwest being as far as I can tell a separate legal entity with its own assets etc. It looks a lot stronger than its parent (RBS) or Lloyds to me.

    I have to stress I don’t see this sort of thing as a core investment for the average private investor. I’m just sharing my thoughts for the interest of more sophisticated Monevator readers.

    If anyone (not yourself, but less knowledgeable readers) are reading this thinking it’s a whole new complicated area to understand – don’t bother, except for interest. These are definitely niche investments, with peculiar risks, and in my view don’t have a place in many portfolios. Stick to the main asset classes for diversification.

  • 5 Matthew Wie December 5, 2013, 8:24 pm

    I now hold a significant proportion of my portfolio in LLPC, NWBD and CPBC (the Coop Preference shares) My yield is around 9% overall which I think is pretty great, so great in fact that I’m considering selling some investment properties and buying a range of preference shares which in theory would give me a greater income with a lot less hassle. Now if yields stuck at around 7% (which is what I can by NWBD at now) I’d be a happy camper for years to come, but unfortunately I don’t feel I understand the impact of interest rates on the prices of preference shares. I assume that as interest rates rise then the yield on preference shares becomes less attractive and for yields to rise, prices fall. However, rates are damn low right now, so wouldn’t they have to rise much closer to say 5% before people start switching from preference shares to gov bonds / cash savings and start depressing preference share prices.

    My question is, as rates rise, is the only way down, for preference shares and should I get out now, and re-buy at presumably higher yields and lower prices when interest rates have ‘normalised’?

    Matt

  • 6 The Investor December 8, 2013, 7:37 pm

    @Matt — They’ve been great investments, haven’t they? Well, most have. The Co-op ones aside. (I presume you’ve been following all that hoo-ha, and know the bank is being restructured etc, and the ramifications for your CPBC?)

    I can’t give specific advice, and happily nobody else can either, because interest rates are the £60 trillion question. It’s only obvious in retrospect, when somebody will always have called it right. But rates are very difficult. Just look at all the people who’ve called a bottom in the bond market for the past 10 years! 🙂

    Which is a way of saying your guess is as good as mine.

    However, Lloyds and Natwest bank preference shares have been driven by solvency concerns as much as interest rates (more so in fact) in recent years. As those fears have abated, their yields have come down to around 7.3 – 7.5% today.

    In contrast, Standard Chartered’s preference shares are yielding about 6.3% from memory. We can compare this with Consol (the long-term perpetual gilt rate) which is about 4.2% at present. So STAN’s prefs are a little over 2% over Consol, whereas the so-called spread on LLPC and NWBD is still about 3%.

    As rate expectations rise, Consol’s yield will rise, though much less sharply than at the short-end. (Hey, you’re already getting 4%). But anyway, as the Consol yield does rise, it’s reasonable to think bank preference shares will rise, too, discounting the normalisation factor as people stop worrying about banks.

    How narrow could that spread be if everyone lost the fear? In the pre-crisis days the spread got as low as about 1.5%. I don’t see that happening again, but if it did there’d be a fair amount of buffer.

    Personally I am holding a few prefs for steady income / ballast, and don’t expect much in capital terms from here. Maybe another 10-20% if bank rate peaks at about 3% in the next 3-5 years?

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