As an investor or corporate finance professional, I often encounter questions about preference shares. What are they? How do they differ from common stock? What advantages do they offer? In this guide, I break down everything you need to know about preference shares—also known as preferred stock—in the U.S. market.
Table of Contents
What Are Preference Shares?
Preference shares are a hybrid security that blends features of both equity and debt. Unlike common stock, they typically do not carry voting rights but offer a fixed dividend payment. Holders of preference shares rank above common shareholders in the event of liquidation but below bondholders.
Key Characteristics of Preference Shares
- Fixed Dividends – Most preference shares pay a fixed dividend, similar to bond interest.
- Priority in Liquidation – In bankruptcy, preferred shareholders receive assets before common shareholders.
- Limited Voting Rights – Generally, preference shares do not grant voting power unless dividends are in arrears.
- Convertibility – Some preference shares can be converted into common stock.
- Callability – Issuers may redeem them at a predetermined price.
Types of Preference Shares
Understanding the different types helps investors choose the right instrument for their portfolio.
1. Cumulative vs. Non-Cumulative Preference Shares
- Cumulative – If a company skips a dividend, it must pay all missed dividends before paying common shareholders.
- Non-Cumulative – Missed dividends are not accumulated.
2. Participating vs. Non-Participating Preference Shares
- Participating – Shareholders receive extra dividends if the company performs exceptionally well.
- Non-Participating – Dividends are fixed, with no additional payouts.
3. Convertible vs. Non-Convertible Preference Shares
- Convertible – Can be exchanged for common stock at a predetermined ratio.
- Non-Convertible – Remain as preference shares indefinitely.
4. Callable vs. Non-Callable Preference Shares
- Callable – The issuer can repurchase them at a set price after a specified date.
- Non-Callable – Cannot be redeemed before maturity.
How Preference Shares Compare to Common Stock and Bonds
To better understand preference shares, I compare them with common stock and corporate bonds.
| Feature | Common Stock | Preference Shares | Corporate Bonds |
|---|---|---|---|
| Dividend/Interest | Variable | Fixed | Fixed |
| Voting Rights | Yes | Rarely | No |
| Liquidation Rank | Lowest | Middle | Highest |
| Convertibility | N/A | Sometimes | Rarely |
Valuation of Preference Shares
The value of preference shares depends on their dividend payments and required rate of return. The formula for valuing perpetual preference shares is:
P = \frac{D}{r}Where:
- P = Price of the preference share
- D = Annual dividend payment
- r = Required rate of return
Example Calculation
Suppose a preference share pays an annual dividend of $5, and the required rate of return is 8%. The value would be:
P = \frac{5}{0.08} = \$62.50If the shares trade below this, they may be undervalued.
Tax Implications of Preference Shares
In the U.S., dividends from preference shares are taxed differently than bond interest.
- Qualified Dividends – Taxed at long-term capital gains rates (0%, 15%, or 20%).
- Non-Qualified Dividends – Taxed as ordinary income.
Most preference shares pay non-qualified dividends, making them less tax-efficient than bonds for some investors.
Risks Associated with Preference Shares
While preference shares offer stability, they carry risks:
- Interest Rate Risk – Rising rates make fixed dividends less attractive, lowering share prices.
- Credit Risk – If the issuer faces financial trouble, dividends may be suspended.
- Liquidity Risk – Some preference shares trade infrequently, making them hard to sell.
Why Companies Issue Preference Shares
Firms use preference shares to raise capital without diluting voting power. They are common in:
- Banking & Finance – Due to regulatory capital requirements.
- Utilities – Stable cash flows support fixed dividend payments.
Real-World Example: Bank of America’s Preferred Stock
Bank of America (BAC) has issued multiple series of preference shares. One example is BAC Series L (NYSE: BAC.PRL), which pays a fixed 6.25% dividend. If an investor holds 100 shares:
\text{Annual Dividend} = 100 \times (6.25\% \times \$25) = \$156.25This predictable income appeals to conservative investors.
Should You Invest in Preference Shares?
Preference shares suit investors who:
- Seek steady income with lower volatility than common stock.
- Are comfortable with moderate risk (higher than bonds but lower than equities).
However, they may not be ideal for those needing capital appreciation or tax efficiency.
Final Thoughts
Preference shares offer a unique middle ground between stocks and bonds. They provide fixed income with higher yield potential than bonds but come with additional risks. By understanding their features, tax treatment, and valuation, investors can make informed decisions.
