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Preferred Stock

| Swing Alpha on 7 Mar 2017 12:00 AM

To a considerable extent, preferred stocks or shares are hybrid securities that are partly debt and partly equity. From an accounting point of view, it is part of equity. The variations of preferred shares depend on the company’s charter and shareholders’ agreement.

This write-up is intended to give a refresher on the more common preferred shares arrangement which is cumulative with anticipated retirement preferred shares. This particular kind of security sets the dates of dividend distribution and the bullet or amortized repayments of the investment. Dividends on preferred shares, although with pre-determined payment dates, set amounts in congruence with benchmarked interest rates. They are not considered an expense, as in interest accruing on debts, and thus are not tax-deductible. However, it provides the necessary muscle to beef up a company’s equity structure making it self-sustaining and well-supported from the creditor’s point of view.

Classification of Preferred Stocks

It is common knowledge that preferred stocks have a priority claim on the assets and earnings as compared to the lower class common stock. This type of shares enjoys a distinct advantage over common shares because of its outstanding claim over a certain amount of dividends prior to distribution to the other shareholders. That makes it superior over common shares.

While preferred shares do not have a “maturity date” per se, some companies arrange for provisions regarding the compulsory or voluntary retirement of these shares. This salient feature of preferred shares makes it a “quasi-debt” instrument. Investors are attracted to this instrument because they get the best of both worlds – guaranteed returns and payback vis-à-vis high-grade securities. While preferred shares do not carry voting rights, it enjoys seniority over common shares when a company is up for liquidation.

Preferred shares are usually issued by companies that have either high or low credit-worthy ratings. There are varied and compelling reasons for the issuance. Companies that have low balance sheet performance find difficulty securing credit lines. However, they can raise capital to fund high revenue-generating projects based on the strength of their expertise or technical know-how.  Some companies use the preferred shares route as a way to comply with SEC requirements for capitalization and licensure. Still, others forego borrowings to maintain good credit ratings.

Negotiable Instrument

Preferred shares are negotiable instruments like bonds and commercial papers. It is sold in the secondary market as a liquidation mechanism for the holders.

  • Pricing these shares depends on the value of the dividends accruing plus the face amount of the shares paid in arrears and discounted based on the remaining tenor within the dividend payment period.
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  • Preferred shares, while senior to common shares are junior to bonds or any other forms of debt.
  • The quasi debt-equity nature of preferred shares can be attributed to the pre-computed value of forthcoming dividends on set dates.
  • Unlike debt, it does not have a maturity date or if ever the contract prescribes a date, it is likely in the distant future.
  • Cumulative preferred shares warrants assured payment of dividends. In cases there is failure or inability of the issuer to meet their commitments, they are mandated to pay the same in the succeeding dividend payment period.
  • The failure, on the other hand, to purchase back or retire the shares on a specified date does not give the holder the right to take legal action or any legal remedy against the issuer. It should be emphasized that these shares form part of the company’s equity and therefore the investment is viewed as ownership, not debt.

Preferred Share Performance

Good performing preferred shares serve as a barometer for the common shareholders. For as long as the issuing company is able to consistently pay the shareholders the dividends and investment repayment, common shareholders are assured of their share of the pie.

Most provisions of a company’s charter regarding management stipulate the voice of preferred shareholders is most likely limited. If ever their vote is required, these shareholders vote in class. When it comes to the issuance of preferred or equal ranking with the existing preferred shareholders, the consent of around 2/3 or ¾ of the outstanding preferred shareholders is required.

Investor preference for this investment instrument is high because of its first-rate features. The direct infusion of funds into the company provides funders the needed comfort in terms of mitigating risks. Investors view the preferred shares as the better alternative to bonds particularly bond offerings with 0% coupon rates.

The Superior Investment Alternative

Preferred shares benefit both the issuer and investor. The issuer’s balance sheet improves and gains the flexibility to redeem those shares over a long period. In addition, they can buy back high-yielding shares and re-issue fresh shares at lower yield. There is also a participating preferred stock which was entitle holders to full payment of principal, accrued dividends and pro-rata sharing of premiums earned in case of liquidation.   

On the other hand, investors have an instrument more stable and liquid than bonds. Most preferred dividends are cumulative and accrue even when dividend payments are suspended. But the real inclination lies in the higher dividend yield and the strength of the issuer’s revenue stream. The final investment decision is still yours to make. We only share info on the available investment options.
3 Mar 2017 4:38 PM | Anonymous

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