What Is a Preferred Share? (Classes, Features, & Examples)
By Indeed Editorial Team
Published June 9, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
There are various securities individuals and institutions can purchase, depending on their investment goals. Preferred stock or shares are a popular option due to certain unique benefits conferred on investors. Understanding what a preferred share is can help you decide if it's a smart financial decision based on your situation. In this article, we answer "What is a preferred share?", outline its categories, discuss its features, explore whether they're an advisable investment, and provide some examples of preferred shares.
What is a preferred share?
To make intelligent financial decisions, it's essential to understand "What is a preferred share?". They're hybrid assets that combine the features of fixed-income securities and common shares. As a result, preferred shares offer a superior claim to dividends over common shareholders.
Categories of preferred shares
Here are some categories of preferred shares:
Fixed-rate perpetual preferred shares
Fixed-rate preferred shares operate in perpetuity, meaning they don't have a maturity date. So, as long as the shares are outstanding, the shareholder can receive a fixed dividend at predetermined intervals. Still, it's important to note that the issuer can redeem fixed preferred shares. Here are some other features of fixed-rate perpetual:
Dividend payment: Fixed-rate perpetual shares usually offer a higher dividend rate than other securities from the same issuer as a reward for investing in a perpetual stock. As a result, it's vital that investors are careful about how much they buy the shares to avoid incurring losses if the issuer redeems the shares.
Calling: Issuers of fixed-rate perpetual can redeem the shares at any time after five years from the date it starts trading. Usually, the dividend terms allow the issuer to redeem the shares at any time, provided they give the shareholder at least 30 days' notice.
Sensitivity to interest rates: Fixed-rate perpetual shares usually perform better when interest rates drop. Securities with higher dividend rates have a lower sensitivity to fluctuations in interest rates.
Rate-reset preferred shares
Rate-reset preferred shares offer the features of both fixed and variable assets. As a result, they're the most popular preferred share option among Canadian investors. These preferred shares pay a fixed dividend for the initial five years after issuance. After this period, the issuer has the option to redeem the shares. If they choose not to exercise that right, the buyer can decide whether to maintain fixed shares for another five years or opt for another type with variable rates.
Floating rate preferred shares
This type of share offers a dividend that changes every quarter, following the Government of Canada's T-bill rate. They result from the holder of rate-reset preferred shares choosing a variable rate alternative after the initial five-year period. It's necessary the shareholder dedicates a minimum amount of fixed-rate shares to covert them to floating rate shares.
Retractable preferred shares
A retractable preferred share is similar to a fixed-rate perpetual one because they pay fixed dividend rates. Still, the significant difference between both types is that the holders of retractable shares can exchange them at a predetermined price and date. The two types of retractable shares are the hard retractable shares and the soft retractable shares. While investors can pay in cash or common shares for soft retractable shares, it's compulsory they pay cash for hard retractable shares.
Features of preferred shares
Here are some of the features of preferred shares:
A major feature of preferred shares which makes them attractive to many investors is that they pay dividends. Both parties reach a consensus on the dividend terms when the issuer furnishes the shares. They may agree on a fixed rate or reference another established rate like the corporate prime rate, the 5-year Government of Canada bond rate, or the quarterly GoC T-bill rate. The agreement states the dividend as a percentage of its $25 face value, which may remain fixed or fluctuate with market conditions.
Typically, preferred shares don't bestow voting rights on shareholders. This makes them a preferred option for issuing companies, as they don't dilute authority like common shares. Still, there's usually an agreement to grant the shareholders voting rights if they've not received their dividends in some cases.
A preferred share is usually callable, which means the issuer can repurchase it at a predetermined date and price. Usually, companies consider if the terms of issuing new shares are favourable before calling existing ones. Generally, companies favour calling existing shares if they can issue new shares with a lower dividend yield. The option to call shares is exercisable at the issuer's sole discretion.
Equity or capital significance
Sometimes, experts refer to preferred shares as hybrid securities because they share the features of bonds and common shares. Companies tend to prefer issuing preferred shares because, like bonds, they don't grant equity to shareholders. This allows the company owners to maintain control while raising funds. Similarly, for financial corporations, preferred shares contribute to their capital. This is important because one of the metrics to assess a financial institution's financial stability is dividing its capital by its assets.
Priority during liquidation
Liquidation is bringing a company to an end and disposing of its assets. In liquidation, all company creditors and shareholders have an order of priority with which the company pays their entitlements. Preferred shareholders have priority over common shareholders, though it depends on the company's discretion. Still, the claim of preferred shareholders is subordinate to that of senior and subordinate debt holders. Senior debt holders have the highest priority, with a claim on any company's assets that isn't loan collateral.
Nature of obligation
Paying dividends to a preferred shareholder isn't a company's legal duty. As a result, missing a dividend payment doesn't amount to a default under law. Companies are within their rights to pause the payment of dividends to common and preferred shareholders. Still, deciding to do this can affect the reputation and market value of the company's shares.
Priority of dividend payment
As with company liquidation, the payment of preferred shares dividends also takes priority over that of common shares. No common shareholder can receive dividends while a preferred shareholder has pending payments. As a result, investors intending to buy preferred shares usually assess how regularly common shareholders receive payment. Regular payment of common shareholders shows that preferred shareholders can expect regular payments as theirs have priority.
When companies that aren't bank or insurance companies issue preferred shares, the dividends are cumulative. This means the issuer remains bound to accrue any dividends they fail to pay for a certain period and pay the total once they resume paying dividends. This is a beneficial feature as it protects the income of shareholders.
All preferred shareholders enjoy tax credits on any dividend payment from their preferred shareholdings. As a result, investing in preferred shares is a more tax-efficient alternative to other securities like bonds, taxable on each payment. Contrastingly, issuing preferred shares is less tax-efficient for issuing companies. This is because companies can only pay dividends after the government has deducted tax from their earnings, unlike debts that the companies pay on earnings before tax deductions.
Typical buyers and issuers
Banks, insurance companies, and energy infrastructure companies are mostly responsible for issuing preferred shares. Buyers comprise both institutions and individuals. Still, institutions tend to buy more preferred shares as they can access tax advantages that aren't accessible to individual buyers.
Is it advisable to invest in preference shares?
Preferred shares grant their holders many rights, which make them preferable. Most importantly, they have greater priority than common shares in case of company liquidation or payment of shares. Additionally, preferred shares often yield a higher dividend. Still, preferred shares face the risk of the issuer redeeming the shares at a lower price than the investor initially bought them. Generally, whether investing in preferred shares is your best option depends on your goal. As they don't trade much higher than their par value, they're best suited for investors who want to make extra income.
Examples of preference shares?
Here are some examples of preference shares you can consider:
iShares TSX/S&P Canadian Preferred Shares Index Fund
This preference share fund is exchange-traded. It works by monitoring and replicating the TSX/S&P preference shares. If you purchase this fund, you can expect to pay a 0.45% fee for management. You can trade it on the Toronto Stock Exchange. Its previous name was Claymore TSX/S&P CDN Preferred Shares ETF, but it got a new name on the 28th of March, 2012.
BMO TSX/S&P Laddered Preferred Shares Index ETF
This exchange-traded fund tracks the TSX/S&P Preferred Shares Laddered Index's performance, excluding any expenses. It observes the proportion of constituent securities the index holds and replicates the investment. You can purchase this security via the Toronto Stock Exchange, with a management fee of 0.450%.
Related: Guide: How to Become a Stockbroker
Malachite Aggressive Preferred Fund
This fund of preferred shares is a privately-traded fund, only accessible to investors with the right accreditation. Hymas Investment Management Inc is the company responsible for managing the fund. It charges a 1% annual management fee on the initial $500,000 investment, 0.75% on the following $500,000, and 0.50% on any remaining amount.
Please note that none of the companies, institutions, or organizations mentioned in this article are affiliated with Indeed.
Explore more articles
- 11 Essay Writing Tips to Help You Become a Stronger Writer
- Guide to Managing Clients (With Definition and Strategies)
- What Is the Return of Equity Formula? (With Example)
- Guide: How to Set up a Meeting (With Helpful Tips)
- List of Sales Gifts Ideas for Sales Associates to Use
- What Is Invoice Financing? (With Types and Examples)
- What Is an Applicant Tracking System? (With Benefits)
- What Are Social Sciences and What Makes Them Relevant?
- Test-Driven Development (TDD) (With Steps to Use It)
- How to Use Automation Testing in 5 Steps (With Skills)
- What Is Web Testing? (With Definition, Types, and Examples)
- Definitive Guide to Secondary Research