8.2.1 Features of Preferred Shares

Introduction to Preferred Shares

Preferred shares are a unique category of equity securities representing a hybrid nature between traditional equity and debt. Investors often opt for preferred shares to enjoy benefits that blend common stock with bonds, making them a versatile security instrument in a diversified portfolio.

Hybrid Characteristics

Preferred shares exhibit hybrid characteristics because:

1. Equity-like Features: As an equity security, preferred shares represent ownership in a company, potentially appreciating in value, and providing voting rights albeit usually more limited than common stock.

2. Debt-like Attributes: Preferred shares resemble debt instruments as they pay scheduled dividends before any dividends are declared on common shares and often at a fixed rate, similar to bond interest payments.

Why Hybridization is Useful

• Stability: Investors seeking stable income streams prefer them for their consistent dividend payout.
• Risk Mitigation: Their precedence in dividend payouts positions them as low-risk compared to common stocks.

Here is a simplified view of preferred shares as a hybrid security:

    graph LR
	A[Common Shares] -->|Ownership| B(Preferred Shares)
	A -->|Dividend Potential| B
	C[Fixed Income (Bonds)] -->|Fixed Returns| B
	C -->|Seniority| B

Fixed Dividends

One hallmark feature of preferred shares is their fixed dividend payments:

1. Precedence Over Common Shares: Preferred shareholders have first claim to dividends before any distribution is made to common shareholders. Even in times of business downturns, dividends to preferred holders are prioritized.

2. Cumulative Dividends: Many preferred shares are cumulative, which means unpaid dividends accrue and must be paid out before common dividend distributions restart.

3. Dividend Magnitude: The size of the dividend is typically predetermined and expressed in either percentage terms or as a fixed dollar amount per share.

Implications of Fixed Dividends

• Investors’ Perspective: Steady dividends make preferred shares attractive to income-focused investors, especially retirees or conservative investors who aim for predictable income streams.
• Corporate Impact: Issuing preferred shares allows companies to seek capital without diluting common shareholder equity or creating a mandatory debt repayment as bond issuance entails.

    sequenceDiagram
	    participant Company
	    participant PreferredShareholders
	    participant CommonShareholders
	    Company->>+PreferredShareholders: Pay Fixed Dividends
	    Note right of PreferredShareholders: Receive first priority
	    Company->>CommonShareholders: Pay Dividends (only if preferred are paid)

Glossary

• Hybrid Security: A financial instrument with characteristics of two or more asset classes, typically equity and debt.
• Cumulative Dividend: A dividend on preferred shares that must be paid before dividends can be paid on common shares and that accrues if not initially paid.
• Dividend Priority: The order in which dividends are declared and paid, particularly between different classes of stock.

Additional Resources

• “Investing in Preferred Stocks: Understanding Risks and Rewards” - An article covering strategies and considerations.
• “Dividend Mechanics in Equity Markets” - A course exploring dividends’ impact on investment returns.

Summary

Preferred shares act as an intermediary security class between equity and debt, offering a unique hybrid profile. Their fixed dividends provide security and predictability to investors, while their priority claim over common dividends enhances their attractiveness as an income-focused investment. For companies, preferred shares represent a flexible financing option with fewer dilution concerns compared to additional equity issues or debt obligations.

Preferred shares, with their blend of features, continue to remain a sophisticated choice for investors balancing the pursuit of stable income against the backdrop of equity growth.