A company has three general buckets of ownership stakes, traditional debt such as a loan, a preferred share, and common stock/equity. When a company is liquidated, each of the investment stakeholders have different priority rights to the remaining company assets. They are traditional debt, preferred shares, and then common equity in that order.
Preferred Shares Basics
With that in mind, what is a preferred share? Also called a preferred stock, a preferred share is an instrument that has both debt and equity characteristics. First, they are issued at a par value much like a debt issuance, and usually pay some amount of dividend, fixed or variable. As an example, a company issues $1,000 in preferred shares at $25 per share which will pay a fixed dividend of 10% per year ($2.50 dollars per year).
These shares then trade on the secondary market where investors can purchase them at premium or discount to par ($25), but the dividend remains fixed at $2.50. Generally, prices of preferred shares fluctuate based on two key factors. First, as interest rates rise, the price of preferred shares (and other debt like instruments) decrease. Second, as the credit rating of the company improves, the price of a preferred share increases. Because the dividend is fixed, but the credit rating has gone up, shares will increase in price to raise the price and lower the yield. Remember, less credit risk equals lower yields of debt like instruments.
Over long periods of time, you should expect your total return for debt would be the lowest, common stock the highest, and preferred shares somewhere in the middle of those two. The amount of risk you are taking is also in-line with the expected return.
Other Key Characteristics
Generally, the issuing company retains a call option on the shares generally at their par value. This means at any time they can buy back the stock from you at $25 without your approval. Preferred shares are typically not callable for a certain period. Generally this is somewhere within 1-5 years.
One key risk of preferred shares is the call risk. As I mentioned before, interest rates or a credit risk improvement could drive the price of a preferred share above its par value. Investors need to be careful if, for example, they purchase a preferred share at $27.00, but it gets called the next day at $25.00, the investor loses the difference. Companies are most likely to call their debt when interest rates drop and/or their credit rating improves.
Some preferred shares stipulate that if the company ever misses a dividend payment, usually due to a bankruptcy or financial trouble, those dividends keep accruing. These are called cumulative preferred shares. This means if a bankruptcy takes several years, your dividends keep accruing and increase your share of a company’s assets under liquidation. Non-cumulative dividends then mean the opposite, all you are entitled to is the par value of your shares.
This is much less commonly available to retail investors, but many preferred shares are convertible to a certain number of shares. For example, at a par value of $25, say a stock price is also $25 per share and you have a one-to-one conversion option. If the stock price were to increase, you would want to convert your shares. This is a benefit to the owner of the preferred share and lowers your yield.
Many preferred shares are issued without voting rights embedded in them. In this case, you are just like any other traditional debtholder. However, preferred shares with complicated voting rights are many times issued to certain executives or historical majority owners of a company, typically the founder. These can have extremely preferable voting rights, such as two-thirds of the vote. They can also be convertible into an extremely high number of shares in the event of a hostile take-over such that an acquirer could never complete a takeover and vote out the preferred share owner.
Why Preferred Shares Instead of Debt?
You might be wondering, if preferred shares act so much like debt, why not just issue debt? There are a few reasons. First, because it is lower on the priority of claims under bankruptcy, current or prospective traditional debtholders will not deem their debt riskier, generally, as a company issues preferred shares. Debtholders must be paid first, so its less of a risk to them. This is also important for companies like banks who have certain capital requirements.
Second, tax deductibility. Dividends on preferred shares are not tax deductible. This leads many companies which do not pay taxes to issue more preferred shares rather than traditional debt. Companies with this tax treatment include REITs and Partnerships, for example. These companies must distribute a certain amount of their net earnings to shareholders, who then in turn pay the tax bill on behalf of the company. Interest deductions for debt would mean nothing to the company as they could not deduct it themselves. However, traditional corporations can deduct interest, so debt can be more advantageous to issue for them.
Preferred shares can be an interesting investment if you are looking for a risk-return profile somewhere between debt and equity. However, they can be extremely complicated securities, and I personally do not recommend purchasing individual preferred shares. There are many ETFs, Mutual Funds, and Closed End Funds which invest in hundreds of these across many different industries. I would recommend that route instead of spending hours researching an individual preferred share, only to have it called away the next day!