Oran A. Hall, Contributor
QUESTION: What are preference shares? Are they good investment instruments?
FINANCIAL ADVISER: Preference shares are company stock on which dividends are paid to shareholders before dividends are paid to owners of common stock, also called ordinary shares.
In the event of liquidation due to bankruptcy, preference shareholders are entitled to be paid from the liquidation of assets before ordinary shareholders. Preference shareholders are owners along with common shareholders.
Although their claims rank above those of ordinary shareholders, they rank below the claims of creditors such as bond and debenture holders. The preference shareholder occupies a position between that of the company's creditors and that of the common shareholder.
Preference shareholders are entitled to a fixed dividend out of the company's past and current earnings after tax. Dividends may be a fixed percentage of the par value of the shares or a fixed dollar amount.
Payment of a dividend is not guaranteed as it is subject to the discretion of the board of directors, who may choose not to declare a dividend so as to conserve funds in the business although the company has made adequate profits for the payment and the cash position may be strong.
Preference dividends are usually paid on a set schedule, but a company may also decide not to pay preference dividends because of a decline of its profits.
Failure to pay an anticipated dividend may have negative repercussions for the company. It may weaken investor confidence, and the general credit and future borrowing power of the company may suffer.
Generally, in the case of a straight preference share, there is nothing that the shareholder can do if a dividend is not paid.
But there are provisions that can protect the shareholder. When the preference share has a cumulative feature, for example, if dividends are not paid when due, they accumulate arrears which must be paid before dividends are paid on common stock or before the preference shares are redeemed.
Preference shares do not have a maturity date. In the event of the winding up or liquidation of the issuing company, preference shareholders are entitled to funds up to a stated amount after creditors and debt holders have been paid in full.
Because most preference shares are essentially fixed-income securities, they trade on a yield basis and do not offer the same potential for capital gains as common stocks do. Generally, their price tends to respond to interest-rate movements, rising when interest rates fall and falling when interest rates rise.
Preference shares are generally purchased as an income investment and trade on stock exchanges. There is very little activity in that section of the local stock market.
Apart from the straight preferred shares that I just discussed, there are several other types, including convertible preference shares, retractable preference shares, and variable or floating-rate preference shares.
Convertible preference shares enable the owner to convert the shares to another class of shares, usually ordinary stock, at a predetermined price for a stated period of time.
The price of this type of preference share rises if the market price of the common stock rises above the conversion price of the preference share.
Compared to ordinary shares, straight preference shares offer greater security, pay a fixed dividend which does not increase, have no voting rights, unless a stated number of dividend payments are in arrears, are less marketable, and have limited appreciation. So they are best suited to conservative investors interested in income.
Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers free counsel and advice on personal financial planning. Email email@example.com.