Advantages and Disadvantages of Preferred Shares

In the previous article, we understood what preferred shares are and also paid attention to their characteristic features. In this article, we will take the conversation forward by understanding the pros and cons of investing in preferred shares. An analysis of the commonly stated pros and cons helps investors evaluate the use of preferred shares for their specific investment objectives.

The details of the advantages and disadvantages have been explained in this article.

Advantages of Preferred Shares

There are several advantages of investing in preferred shares from an investor’s point of view. The details of these advantages have been mentioned below:

• Priority Payments: Firstly, it is important to note that preferred shareholders are given priority payments. This is because the nature of the financial instrument is such that the company has to first pay the priority shareholders before they can make any payments to common stockholders. These priority payments virtually guarantee coupon payments at a higher rate until the company runs into cash flow issues and reaches the verge of bankruptcy.

• Lower Default Risk: Preferred shareholders are considered to be senior in the debt structure of the firm. This means that in the unfortunate event of dissolution or winding up of the firm, the preferred shareholders will have a higher claim as compared to equity shareholders. This means that the default risk of preferred shares is considerably lower as compared to the default risk of regular shares.

• Tax Advantages: In the United States, the income received from preferred shares receives a preferential tax treatment. There are certain kinds of preferred stock that have been listed down in the tax code. The dividend received from these shares is taxed at a significantly lower rate as compared to regular income tax rates.

• Convertible to Common Stock: Many preferred stocks give the investor the option to convert their share into common stock if they wish to do so. Of course, since the value of this option has to be taken into account, the dividend paid by these preferred shares tends to be lower than other shares.

  Investors are generally keen on investing in preferred shares which have convertible features. This is because they get the best of both worlds i.e. a fixed income at a higher rate in the initial years and an option to convert the preferred shares to common stock only if it is beneficial for them to do so.

Disadvantages of Preferred Shares

While investment in preferred shares is generally considered to be a safe bet, there are several disadvantages that result from such investments as well. Details of some of these disadvantages have been mentioned below:

• Dividend Deferral Risk: Firstly, preferred shares have to be evaluated in a way that is very different as compared to bond investments. In the case of bond investments, investors only have to take into account the risk of default.

  Here, there are other types of risks that need to be accounted for. For instance, the issuer may not be able to make dividend payments in a given year and may have to defer the same. In such cases, preference shareholders have no recourse and have to forego the payment that year. This means that the investors cannot rely completely on these dividend payments as a source of their income.

• No Claim on the Company: Preference shareholders get no real claim on the company. This means that their title is not secured by any particular asset. Instead, they will be paid only if there is a residual value that is left over after paying all the senior creditors.

  They are only senior to equity shareholders when it comes to the dissolution of the firm. Hence, it can be said that they do face the risk of default to some extent. This makes preference shares riskier since the downside is the same as bonds but the upside is less as compared to bonds.

• Retractable and Redeemable: The specific features which are embedded in preference shares differ from company to company. However, in most cases, the shares are either retractable or redeemable. Being retractable means that the shares can be called back by the company. In such cases, the company can make a unilateral decision to return the face value of the preference share and extinguish it.

  The market value of the preference share is not taken into account while deciding on the compensation to be provided to the shareholder. Similarly, the preference shares may be redeemable. In such cases, the investor and not the issuer may have an option to unilaterally force the company to buy back their shares at the original price. Once again, the prevailing market price is not taken into consideration.

  Preference shares may be retracted if their market value is far above their par value and may be redeemed in the opposite case. In either case, one party may have the power to enforce a disadvantageous trade on their counterpart. This is one of the reasons which makes investing in preference shares dangerous.

The reality is that preferred shares have an intermediate level of risk and provide a commensurate return. However, since preferred shares are generally issued by companies in the banking and financial sector and these companies are less prone to default as compared to other companies, these shares are generally considered to be a safe bet.