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.
Preferred Shares: 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.
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 that would also be $1.25 (5%x$25).
- A “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.
Preferred shares rank in seniority after all debt of a company but before the common shareholders. This means that in bankruptcy, 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 debt holders. If an interest payment is missed, the debt holders 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 its own. A (non-exhaustive) list 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 that insulate against market setbacks, common stocks have much lower dividend payouts that expose the holder to a much higher level of capital risk.