What you need to know about preference shares and hybrids

There are different types of shares on the stock market for investors to buy. The most common is ordinary shares but there is also another type of share called preference shares. These are sometimes referred to as hybrids as these are products which have debt and equity characteristics. Preference shares provide investors with a regular stream of income which means it is similar to the characteristic of a bond. They may also have a fixed maturity date. Preference shares are similar to ordinary shares where the instrument pays the income through a dividend. It is useful to know all the available financial instruments to invest in so here are some of the characteristics of preference shares.

Differences between preference shares and ordinary shares

Ordinary shareholders have voting rights, preference shareholders however do not have this right.

Dividend payments on ordinary shares are not guaranteed however preference shareholders have a fixed dividend which is regularly paid. The dividend yield on preference shares is also higher than ordinary shares. The yield is comparable to corporate bonds. This means that investors looking for income could consider preference shares.

In the event of bankruptcy, preference shareholders will be given priority over ordinary shareholders when dividends are paid out. Shareholders get whatever is left after lenders, preferred stockholders, employees and lawyers.

Different types of preference shares

Cumulative versus non-cumulative dividends – Preference shares can pay dividends cumulative or non-cumulative. This means if a company issues preference shares that are non-cumulative and they do not declare a dividend in a particular year then these shareholders lose their right to receive a dividend for that year. Preference shareholders of cumulative dividends must be paid the dividend that year or at a later date.

Convertible versus non-convertible shares – Convertible preference shares can be converted into ordinary shares at an agreed time. An investor may decide to convert their preference shares into ordinary shares if they see a rise in the stock price. Investors do not need to wait until maturity date to exit their investment as they can sell it on the Australian Stock Exchange. Some companies offer investors the choice of paying cash at maturity date as instead of converting the shares into ordinary shares.

Redeemable versus non-redeemable – When redeemable preference shares reach maturity, the company will repay the capital amount to the shareholders and cease dividend payments. Non-redeemable preference shares do not have a maturity date but have a fixed dividend.

Why would a company issue preference shares?

Large corporations can raise capital by issuing more stock. However, this dilutes the holdings of existing shareholders. They can also raise funds through debt but this means they need to pay the interest costs. Companies may decide to issue preference shares to raise capital as it creates a lower debt to equity ratio. This in turn will make balance sheets look more favourable to investors.

Who is it suitable for?

Investors who are risk averse would find preference shares suitable. They are less volatile than ordinary shares and they provide steady dividend payments. Investors looking for income in their portfolio and want to invest in equities but do not want to experience the wide price fluctuations would find preference shares ideal.

Lauren Hua is a private client adviser at Fairmont Equities.

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