Understanding the role of preferred stocks

  • Getting bigger: a diagram showing how a small, privately held company can grow into a large capitalised entity. Along the way it gathers capital by issuing shares, which might also include preferred stock

    Getting bigger: a diagram showing how a small, privately held company can grow into a large capitalised entity. Along the way it gathers capital by issuing shares, which might also include preferred stock


This is part of the Bermuda Fundamental Financial Planner Primer; Segment Two — the First Bermuda Investment Primer

A reader wrote after last week’s article about the pros and cons of share buybacks, and asked: “Why would I want to own preference shares? To me, they seem like a poor investment.”

There were further questions regarding the IPO [initial public offering] fees and commissions earned by financial institutions and brokers — this second question block can fill a book by itself — so I will move it forward to a future article.

The issuance of preferred shares by a publicly traded company is done for a number of reasons.

First, how does a public company get to that point?

Common stock

A brief revisit of last week described a privately held company issuing common shares to the general public for purchase in an IPO. Once that event is over and the cash has been received by the now public company, the stock can be purchased at random by trading between various owners on secondary investment markets. The company itself has little control over stock prices or ownership in the public domain, although they do generally keep (in their Treasury) a sufficient majority of common shares to maintain control.

Thus, a tiny successful company is capable of scaling upward through growth phases and market capitalisation from: a private firm, to an IPO into the public capital market domain, then growth from micro cap, to small cap, then mid cap, to large cap and the final mature mega-giant companies we see in the Dow, the S&P and in the news every day. Who can miss mentions of Google, Amazon, Facebook, and Apple?

Capital markets being what they are, trade stock and other securities on many variables: uncertainty, sentiment, analyst opinions, valuations, fear, popularity, risk assessment, volatility, political statements, natural disasters, and so on. This activity can accelerate large share price swings in common stock valuations.

Capitalisation sources

The underlying public companies’ main goals are profit-focused, stable, growth along with meeting the demands and concerns of their shareholders. As a company’s industry market penetration continues to grow, the need for further capital (ready cash) increases also. In this respect, financial strategies for companies are not so different than individual investment planning. Diversification is always a good idea as the differences between common and preferred provide a counterpoint.

Companies often create a second class of stock called preferred or preference shares, (because they are first to receive company dividends). There are numerous preferred share types, but as space is limited, preferreds, in general:

• are used to raise capital

• fend off hostile takeovers

• keep lending within company boundaries

• increase capital without diluting existing shareholder rights

• are considered an alternative form of financing without the requirement of scheduled bondholder mandatory interest payments

• in some countries, are issued as Tier 1 capital to satisfy regulatory requirements

• have less volatility than common shares while trading in a narrowly defined range

• have a right to a recuperative payment in bankruptcy

• can be called at par with notice by the issuer

• are less volatile within capital markets

• share prices float in a tight range and are redeemed on notification at a set price,

• considered better credit quality than common stock

• have certain tax advantages in the US

• preferreds do not participate in the growth of the company

• are not considered equity of the company

• can be convertible into common shares

• are subordinate to bonds in creditor attachment, eg bankruptcy

• have no voting rights, thereby no dilution of common share control.

Dividends paid are set at a fixed amount, an attractive feature in low interest rate environments and while not mandatory, have a significantly higher priority of payment than common share dividends.

Preference shares have been compared to, and considered an emulation in some ways to fixed-income (bond) debt with preferred prices rising and falling inversely to market interest rates.

Preference shares, or preferreds, are a favourite for their issuers, public corporations concentrated mostly in the financial sector of banks, utilities, and insurance companies, including Bermuda international business insurers.

The share offerings are issued, generally, at $25 per share Almost without fail, a quarterly dividend is paid. The preferred principal can be called (redeemed) by the issuer at a set date, but in a low interest rate environment preferreds with high dividend rates may be called early to be replaced with lower dividend rate new issues. Perpetual preferreds have no set redemption.

Preferreds tend to trade in a narrow range, without the volatility and market value uncertainty of common shares.

When capital markets were wildly fluctuating, investors were not too fussed. When interest rates were low, their preferred dividend rate did not change. When the share market value popped above that call par value redemption price, the shares could be sold at a small profit.

These share issuances seemed so reliable and dependable that they were assumed to be a guaranteed sure thing, but it can be a misperception.

When markets are in crisis. Reality is different.

If an underlying issuer corporation experiences significant financial distress, the preferred share prices will be stressed as well. Such a particular situation was aptly embellished during the 2008 financial crisis when Lehman common stock and preferred share market values dropped precipitously in a matter of months, ending with the firm’s demise in September 2008, a victim of the sub-prime mortgage market crisis.

Taxation

Preferred share dividends owned by foreign investors, and sited in the United States are subject to a US 30 per cent withholding tax. US citizens and US green card holders may receive a qualified dividend tax rate of 15 per cent. The dividends, nor the stock, are guaranteed.

Canada, UK, Germany, and other country investment markets also offer their domestic preferred shares, subject to varying tax rates and qualifications.

Preferred shares have place in a diversified portfolio. A portfolio, solely comprised of preferred shares (with high dividend rates) may seem genius-driven, but one never knows when a Black Swan event could torpedo such a concentration of risk. Reference Lehman — all things in moderation.

Sources:

• Bermuda Stock Exchange, see Listed International Companies

• Wikipedia

• Market experience

• Investopedia. The Collapse of Lehman Brothers: A Case Study By Nick Lioudis Updated June 7, 2019.

• Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to The Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: martha.myron@gmail.com

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Published Jun 22, 2019 at 8:00 am (Updated Jun 22, 2019 at 12:17 am)

Understanding the role of preferred stocks

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