8.3.5 Straight Preferred Shares

Straight Preferred Shares

Straight preferred shares are preferred stocks with standard preferences concerning asset and dividend entitlements ahead of common stocks. These shares don’t come with any additional features. They offer a fixed dividend for as long as they remain outstanding, and trade in the market on a yield basis. Similar to bonds and debentures’ market prices, straight preferred shares’ prices are influenced by interest rate fluctuations.

Market Behavioral Pattern

• If interest rates rise: The fixed dividend payment loses its relative value, causing the market price of straight preferred shares to fall.
• If interest rates decline: The fixed dividend payment gains more value, leading to an increase in the market price of straight preferred shares.

Example Scenario

A company issues preferred shares with a par value of $50 and a fixed dividend rate of 3% (resulting in an annual fixed dividend payment of $1.50 per share).

• When interest rates rise, new fixed-income issuers offer higher yields to match the current rates, making the 3% yield on previously issued preferred shares appear too low. Consequently, the price of these shares drops below $50. This price drop offers potential buyers a higher yield, calculated as the dividend divided by the current market price.
• Conversely, when interest rates fall, the yield becomes more attractive, increasing the market value of the preferred shares above par value.

Characteristics of Straight Preferred Shares

From an investor’s viewpoint, straight preferred shares present the following features:

• Preference: They offer higher security than common shares due to their prior claim on dividends and assets.
• Tax Advantage for Individuals: Individuals can benefit from the dividend tax credit.
• Tax Advantage for Corporations: Corporations can gain a tax advantage, as dividends received from Canadian companies are tax-exempt for them.
• Less Secure than Debt Investments: Unlike debt investments, dividends on preferred shares are not a legal obligation.
• No Voting Rights: Preferred shareholders lack voting rights unless dividend payments have been in arrears for a stipulated period.
• No Maturity Date: These shares don’t have a set maturity date.
• Marketability: Preferred shares tend to be less marketable than common shares due to their lower issuance volume.
• Limited Price Appreciation: The appreciation potential is usually capped by the price at which the issuer can redeem the shares.

Key Takeaways

• Market prices of straight preferred shares fluctuate with interest rates, much like bonds and debentures.
• They offer advantages in tax liabilities for both individuals and corporations.
• Straight preferred shares deliver a fixed return, providing security over common shares but with lower foreclosure odds than debt investments.
• They come with trade-offs like limited price appreciation and no voting rights.

Glossary and Definitions

• Par Value: The face value of a share, as defined in the company’s charter.
• Dividend Yield: The annual dividend payment divided by the current market price of the share.
• Dividend Tax Credit: A tax credit that individual shareholders receive for dividends paid by Canadian corporations.
• Arrears: Overdue and unpaid dividends.
• Marketability: The ease with which a security can be bought and sold in the market without affecting its price.

Frequently Asked Questions

Q1: How is the yield of a straight preferred share calculated?

A1: The yield is calculated by dividing the annual dividend by the current market price of the share. For example, if the annual dividend is $1.50 and the current market price is $45, the yield is \( \frac{1.50}{45} \times 100 \approx 3.33% \).

Q2: What factors influence the market price of straight preferred shares?

A2: The main factors influencing the price are broader interest rate movements and supply-demand dynamics in the market.

Q3: Can straight preferred shares be converted into common shares?

A3: No, straight preferred shares typically do not come with conversion features. They are different from convertible preferred shares which can be converted into a specified number of common shares under certain conditions.

Visual Representation

Below is a simple flow to illustrate how interest rates affect the market price of straight preferred shares:

    flowchart TD
	    A[Interest Rates Rise] --> B[Fixed Dividend Less Valuable]
	    B --> C[Market Price Falls]
	    D[Interest Rates Fall] --> E[Fixed Dividend More Valuable]
	    E --> F[Market Price Rises]