The one thing constant about preferred shares is their
seniority. Preferred shareholders are the senior equity holders in a company
and have "preference" in terms of dividend payments and
distributions in the case of bankruptcy. Beyond this, preferred shares come
in many varieties. Their payment terms and structure are very flexible and
lead to the many different types of preferred shares available in the
financial markets.
Term or Maturity
A good starting place for considering preferred shares is to look at
the term or maturity provided for in their structure. Usually the name of
a preferred share gives away its term nature:
- A "straight" or "perpetual" preferred
share has no fixed maturity date. It pays its stated dividend forever or
"in perpetuity".
- A "retractable" or "term" preferred share has its maturity set at issue. A five year retractable
preferred would have a $25 "par value" which would be
repayable by the issuer five years from the date of issue.
- A "soft-retractable" preferred share is a preferred
share that has its retraction value payable in "hard cash" or
in an equal value of common stock of the issuer, at the choice of the
issuer. This provision means that the issuer could avoid a cash payment
at maturity or retraction and pay in stock issued from treasury. These
issues normally provide for the stock price used to calculate the number
of shares required to be 95% of the average price of the common shares
in a time period before the retraction occurs. This is meant to penalize
the issuer by making the stock payment option expensive to the issuer
and other common shareholders because of the dilution effects.
Payment Provisions
Preferred shares provide for their payment terms when they are issued.
Once again, the name of the preferred usually gives away its payment
provision:
- A "fixed-rate" preferred provides for a set or "fixed-rate"
dividend upon issue, usually declared and paid quarterly. This can
either be set as a fixed dollar value dividend or a stated percent of
the par value. For example, a $25 par preferred share might set a $1.25
annual dividend or provide for a 5% of par payment which would also be
$1.25 (5%x$25).
- "Floating-rate" preferred shares provide for a
dividend that is paid by reference to a market interest rate. For
example, a common Canadian structure is to use a percentage of the
commercial bank prime rate. If the preferred provisions say 80% of the
prime rate payable monthly, the prime rate divided by twelve would be
taken each month and multiplied against the par amount and 80% of the
result would be paid out to the preferred shareholder.
- A "Dutch Auction" preferred share has its interest
rate set as the outcome of a "reverse auction" where
bidders indicate the interest rate that they are willing to accept on an
amount of the subject preferred share. The bids are then examined and
the highest bid "clears" the auction. In this fashion, the
interest rate can be set on these preferred shares on a monthly or
quarterly basis.
Dividend Priority
Preferred shares rank in seniority after all debt of a company but
before the common shareholders. This means that in bankruptcy that the
preferred shareholders would get anything left over after the debt holders
have been repaid and before the common shareholders. In a normal
situation, it also means that the preferred shareholders have priority in
receiving dividends. Preferred share terms usually specify that no common
share dividends can be paid if preferred share dividends are not paid as
required. This sounds good, but in normal situations the preferred
shareholders have much more limited leverage than the debtholders. If an
interest payment is missed, the debtholders can force the company into
default. If a company cannot make a preferred dividend, its board can
always decide not to pay it. In fact, most bond covenants provide for no
dividend payments, distributions or redemption of preferred shares if
these would result in default under the terms of the bond indentures.
Usually, the most severe sanction provided for in preferred share
structures is the right for preferred shareholders to appoint a
representative (s) to the board of a company if a preferred dividend is
missed.
Most preferred shares are "cumulative" which means
that skipped dividend payments are accumulated until they are finally
paid. For example, a company that missed two years worth of preferred
share dividends would have to pay all the missed payments before it paid
out anything to the common shareholders. Recently, there have been
attempts by companies to make distributions to common shareholders even
though the preferred shares were in arrears. This is tempting for
companies, as the preferred shareholders do not have votes and thus a
voice in the corporate governance. These attempts resulted in legal
actions and some sort of settlement with the preferred shareholders.
"Non-cumulative" preferred shares do not accumulate
dividends that are in arrears. In the last six years, financial
institutions have been issuing preferred shares as subordinate capital to
meet the international capital standards. The reason for this is that bank
regulators want capital that ranks after the banks' deposits and gives
them some flexibility in financial difficulties. Non-cumulative preferred
shares meet this test as they can have their dividends suspended without
penalty. The only provision on these shares is usually that common
dividends cannot be paid if the preferred dividends are not being paid.
Types of Preferred Shares
The various features for preferred shares make for a number of "permutations
and combinations" as math teachers are fond of saying. This leads to
a preferred share vocabulary or "lingo" in a world all of its
own. A (non-exhaustive) listing and explanations of the various types is
given below:
- Fixed-Rate (Hard) Retractable: fixed coupon/dividend with set
term with par amount payable in cash at maturity.
- Soft-Retractable: fixed coupon/dividend with set term to
retraction in cash or stock at 95% of market price.
- Floating-Rate Retractable: floating rate coupon/dividend with
set term and par amount repayable in cash at maturity.
- Fixed-Rate Perpetual (Straight): fixed coupon with no set
term.
- Floating-Rate Perpetual: floating-rate with no set term.
- Fixed-Floater: a fixed rate coupon with change to floating
rate perpetual at end of term
Confused? You should be. Preferred shares are way beyond the average
investor's bailiwick and there is a steep learning curve for those who
want to develop this expertise. A good "Dividend" mutual
fund solves the expertise problem but watch out for common stock wolves in
preferred sheeps' clothing. Many dividend funds are heavily invested in
common stock with very low dividend yields. While preferred shares have
high coupons/dividends which insulate against market setbacks, common
stocks have much lower dividend payouts which expose the holder to a much
higher level of capital risk.
As in all things investment, know what you're buying.
Keep on reading the Financial Pipeline and
Preferred Caveat Emptor!!!!!!! |