14.4.1 Creditor Preference

Introduction to Creditor Preference

The concept of creditor preference plays a significant role in evaluating the investment quality of preferred shares. Within the wider capital structure of a company, preferred shares occupy a unique position. They represent a hybrid investment—offering the potential for higher income returns than common shares, but possessing less capital appreciation potential. Importantly, creditor preference dictates where preferred shares stand if a company is liquidated. This article will explore the priority of claims in this context and how it influences the attractiveness of preferred shares as an investment.

Capital Structure and Priority in Claims

Understanding the capital structure of a company is essential for investors looking to assess risk and return. A typical capital structure includes:

• Common Equity: Represents ownership in the company, yet holders are last in line during liquidation.
• Preferred Shares: Offer fixed dividends and sit above common equity in the hierarchy of claims.
• Debt Instruments: Comprising bonds and debentures, these have the highest claim priority.

Let’s visualize the priority of claims in a company’s capital structure using a Mermaid diagram:

    graph TD;
	    A[Debt Instruments] -->|Highest Priority| B[Preferred Shares];
	    B -->|Middle Priority| C[Common Equity];
	    C -->|Lowest Priority| D[Residual Claims];

Preferred Shares in Liquidation

In liquidation scenarios, preferred shareholders have a greater claim than common shareholders but are subordinate to debt holders. This intermediate position provides a balance between security and potential for dividends, influencing the risk-reward calculation preferred share investors must consider.

Process of Claim Satisfaction

1. Secured Debt Holders take precedence, being first in line to recover their investments from the company’s assets.
2. Unsecured Debt Holders follow, receiving repayment after secured creditors.
3. Preferred Shareholders hold claims to residual value remaining after debt holders are satisfied but precede common shareholders. Their dividends, although subordinate during operating times, must be fully paid before any dividends on common shares.

Assessing Investment Quality

To determine the quality of a preferred share investment, investors should consider the following factors:

• Creditworthiness of the Issuer: Companies with strong credit ratings are more likely to meet their dividend obligations even during financial stress.
• Dividend Coverage: Evaluate the firm’s ability to cover dividend obligations through operational cash flow.
• Cumulative vs. Non-Cumulative: Cumulative preferred shares offer more protection as unpaid dividends accumulate and are prioritized.
• Convertibility: Some preferred shares convert to common stock under specific conditions, which can introduce additional valuation influences.

Conclusion

Preferred shares occupy a middle ground in the capital structure with a distinct claim priority, providing a blend of equity and debt characteristics. Understanding the framework of creditor preference assists investors in evaluating both the benefits and risks associated with preferred shares. These instruments can be incredibly beneficial for income-focused portfolios, particularly within a robust corporate structure where liquidation risks are minimized.

Glossary

• Capital Structure: The combination of debt and equity used by a company to finance its operations and growth.
• Cumulative Preferred Shares: Preferred shares that accumulate unpaid dividend obligations, ensuring eventual payment before common dividends.
• Creditworthiness: An assessment of a company’s financial solvency and ability to pay its debts.
• Liquidation: The process of dissolving a company and distributing its remaining assets to creditors and shareholders.

Additional Resources

• Canadian Securities Course (CSC®) Study Material
• Investopedia – Preferred Shares

Summary

Creditor preference and priority in claims significantly influence the perceived risk and attractiveness of preferred share investments. By understanding these dynamics within a company’s capital structure, investors can make informed decisions about incorporating preferred shares into their portfolio strategies.