Preference Share: Meaning and Types

Preference shares are a special type of stock offering fixed dividends and priority over common shares for dividend payments and asset liquidation. They typically don't provide voting rights, making them an attractive option for investors seeking stable income with lower risk than common stocks. 

Preference shares are a type of stock in a company that offers some advantages over common shares. They typically provide fixed dividends and priority in receiving dividends or assets if the company goes bankrupt. However, preference shareholders usually don't have voting rights in company decisions. These shares blend features of both equity and debt, offering a unique investment option with a mix of stability and potential income. 

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Table of Content

• Preference Share Meaning
• What are Types of Preference Shares?
• Benefits of Investing in Preference Shares
• Risk Associated with Preference Shares

Preference Share Meaning

A preference share, in stock market terms, is a type of company stock that gives shareholders preferential rights over common stockholders. These rights typically include receiving dividends before common shareholders and a higher claim on assets if the company is liquidated. Although preference shares generally don't carry voting rights, they offer a less risky investment compared to common shares, making them attractive to conservative investors seeking steady income.

What are Types of Preference Shares?

Cumulative Preference Shares: Cumulative preference shares guarantee unpaid dividends accumulate and are prioritized for payment over common shares.

Non-Cumulative Preference Shares: Non-cumulative preference shares do not accumulate unpaid dividends. If the dividend is skipped in a year, it is not carried forward to future years.

Participating Preference Shares: Besides receiving a fixed dividend, these shares may also get an additional dividend based on company profits, akin to common shareholders.

Non-Participating Preference Shares: These shares only entitle the holder to a fixed dividend, with no participation in additional company profits.

Convertible Preference Shares: These can be converted into a predetermined number of common shares at specific times during their tenure.

Non-Convertible Preference Shares: These cannot be converted into common shares and only offer fixed dividends.

Redeemable Preference Shares: These shares can be redeemed or bought back by the company after a certain period or on specified dates.

Irredeemable Preference Shares: These shares do not have a redemption clause and are only redeemable upon company liquidation.

Benefits of Investing in Preference Shares

Investing in preference shares offers several benefits, making them an attractive option for certain types of investors:

Fixed Income: Preference shares typically pay fixed dividends, providing a steady income stream. This makes them appealing to investors seeking regular and predictable returns.

Priority on Dividends: Preference shareholders are paid dividends before common shareholders, ensuring they receive income even when a company limits or cuts dividend payments.

Reduced Risk: Since preference shares have a higher claim on assets and earnings, they are generally considered less risky compared to common shares, especially in cases of bankruptcy or liquidation.

Potential for Additional Earnings: Participating preference shares offer the possibility of additional dividends that are tied to the company’s profitability, similar to common shares.

Convertible Options: Convertible preference shares provide the opportunity to convert into common shares, allowing investors to participate in the company’s equity growth.

No Obligation for Dividend Payments: For non-cumulative preference shares, if the company faces financial difficulties, it is not obligated to pay dividends, reducing financial pressure on the company.

Fixed Redemption Value: Redeemable preference shares have a fixed redemption value and date, providing clarity and a degree of capital protection for investors.

Diversification: Adding preference shares to an investment portfolio can provide diversification, balancing risk and return effectively.

Risk Associated with Preference Shares

Interest Rate Sensitivity: Preference shares are prone to interest rate fluctuations. When rates rise, their value often falls, similar to bonds. This is because their fixed dividend becomes less attractive compared to newer issues, offering higher returns. Investors need to be wary of potential capital losses in a rising rate environment.

Limited Capital Appreciation: Unlike common stocks, preference shares generally offer limited growth in share value. Their fixed dividend cap limits potential earnings, making them less suitable for investors seeking capital growth. Preference shares are more about steady income than appreciating asset value.

Dividend Risk: For non-cumulative preference shares, if a company faces financial strain and skips dividend payments, investors won't receive those dividends later. This risk makes them less reliable for investors who depend on regular dividend income, as missed payments are not necessarily recovered.

Redemption Risk: Companies can redeem preference shares earlier than their maturity date, often at a set price. This can be disadvantageous for investors, especially if the shares are offering good returns. Early redemption can force investors to reinvest at lower prevailing rates.

Market Liquidity: Preference shares typically have less liquidity than common stocks, making it harder to sell them quickly without affecting their price. This can be a significant risk for investors who might need to convert their shares into cash promptly.

Callable Feature: Many preference shares are callable, allowing the issuing company to buy them back at a pre-set price. This feature can limit the upside for investors, especially if the shares are called back in a low-interest-rate environment, forcing investors to reinvest at less favorable rates.

Conclusion

Preference shares are a unique investment choice, offering a blend of equity and debt features. They provide investors with fixed dividends and priority over common shareholders in profit distribution and asset liquidation, but usually without voting rights. While they offer stability and regular income, investors should also be mindful of their limited growth potential and specific risks like interest rate sensitivity and market liquidity.