A preference share is like a halfway house between an ordinary share and a corporate bond [1].
If that sounds like something from Alice in Wonderland, you’re not far wrong.
The risk versus return [2] 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 [3] 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 [4] 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 [5] in Goldman Sachs during the banking crisis, for instance.
During the same period, investors who bet that UK banks [6] wouldn’t go bust by buying their preference shares [7] 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 [8] – 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.