8.2.2 Types of Preferred Shares

Introduction to Preferred Shares

Preferred shares are a class of stock that grants shareholders certain privileges over common shareholders, particularly in terms of dividend payments and liquidation preferences. Unlike common shares, preferred shares typically do not carry voting rights but they do offer a fixed dividend, which must be paid out before dividends can be issued to common shareholders. In this section, we explore various types of preferred shares, focusing on the distinctions between cumulative and non-cumulative shares, as well as convertible and non-convertible shares.

Cumulative and Non-Cumulative Preferred Shares

Cumulative Preferred Shares

Cumulative preferred shares provide a unique advantage to shareholders: the assurance of recovering unpaid dividends. If a company faces financial difficulties and is unable to pay dividends on its cumulative preferred shares, these unpaid dividends, known as “dividend arrears,” accumulate. The company is obligated to pay these arrears before issuing dividends to common shareholders.

Characteristics of Cumulative Preferred Shares:

• Dividend Accumulation: Missed dividend payments accrue over time.
• Prioritization of Payments: All accumulated dividends must be cleared prior to any distribution to common shareholders.
• Investor Appeal: These shares appeal to risk-averse investors who seek consistent returns even in uncertain financial conditions.

Non-Cumulative Preferred Shares

In contrast, non-cumulative preferred shares do not hold the same assurances regarding dividend payments. If a company fails to declare a dividend during a financial period, those dividends do not accumulate or carry forward to future periods. This makes non-cumulative preferred shares more sensitive to company performance when it comes to income distribution.

Characteristics of Non-Cumulative Preferred Shares:

• Forfeiture of unpaid dividends: If dividends are not declared, shareholders cannot claim them in future periods.
• Dependent on Company Performance: Ideal for companies with stable and predictable earnings.
• Potential for Higher Dividends: Sometimes offered at a higher dividend rate as compensation for not accumulating unpaid dividends.

Convertible and Non-Convertible Preferred Shares

Convertible Preferred Shares

Convertible preferred shares offer shareholders a hybrid between debt and equity. They provide the option, but not the obligation, to convert preferred shares into a predetermined number of common shares, usually at pre-agreed terms. This conversion feature is particularly attractive during periods of expected company growth or rising share prices.

Characteristics of Convertible Preferred Shares:

• Flexibility and Growth Potential: Investors can convert when it is financially advantageous.
• Reduced Fixed Returns: Often come with lower dividend rates due to potential conversion benefits.
• Dilution Risk: Conversion could dilute the value of existing shares if not managed properly.

Non-Convertible Preferred Shares

As the name suggests, non-convertible preferred shares lack a conversion feature. They resemble traditional preferred shares, offering fixed dividends without the potential to convert into common shares. These shares attract investors seeking stable and predictable income streams minus equity volatility.

Characteristics of Non-Convertible Preferred Shares:

• Stable Income: Provides steady and predictable dividend income.
• Fixed Characteristics: No conversion risk; remains as a preferred share throughout its lifespan.
• Simple Structure: Simpler to understand, sometimes with more favorable terms for non-conversion risk considerations.

Visualizing Preferred Share Types

To provide a better understanding of these different types of preferred shares and their features, the following Mermaid diagram illustrates the key distinctions and relationships:

    graph TD;
	    A[Preferred Shares] --> B(Cumulative)
	    A --> C(Non-Cumulative)
	    A --> D(Convertible)
	    A --> E(Non-Convertible)
	    B --> F[Accumulated Dividends]
	    C --> G[Dividends Don't Accumulate]
	    D --> H[Conversion Option]
	    E --> I[Fixed Income Stability]

Summary

In summary, preferred shares serve as a flexible financial instrument bridge between common equity and debt due to their hybrid nature—offering components of both fixed income and equity characteristics. Cumulative shares protect shareholders by ensuring missed dividends are eventually paid. Non-cumulative shares pivot on current period returns, while convertible shares provide conversion options for potential growth. Non-convertible shares emphasize consistent yields. Understanding these distinctions allows investors to choose instruments that best align with their financial strategies and risk profiles.

Glossary

• Cumulative Preferred Shares: A type of preferred stock where missed dividend payments accumulate until paid.
• Non-Cumulative Preferred Shares: Preferred stock where missed dividends are not accrued.
• Convertible Preferred Shares: Shares that can be converted into a predetermined number of common shares.
• Non-Convertible Preferred Shares: Preferred stock without conversion rights, focusing on consistent income.

Additional Resources

• “Guide to Investing in Preferred Shares” by Casey Murphy, available on Investopedia.
• “Understanding Preferred Shares” by Corporate Finance Institute for foundational knowledge.
• The Canadian Securities Institute for additional exam preparation materials.

This detailed exploration should enhance your preparedness for the CSC® Certification Exams in understanding the nuances of equity securities within the Canadian market.