22. What is a Preferred Share?

What is a preferred Share?

Risk: Bond < Preferred Share < Common Share

Like a Bond: Preferred shares pay dividends instead of coupons
Like a Common Stock: A preferred share is a proportional piece of equity in a business

What are considerations when buying a preferred share?

Read the certificate of designation

• Cumulative Preferred: You'll eventually get your dividend but you might not have the ability to compound a consistent dividend payment
• Non-cumulative Preferred: Never ever buy this one

The reasons that CEO or common share holders like to have preferred shares are that they have a power to control it. It is a good way to raise the money for companies requiring a lot of money such as companies that just did IPO. If the issued preferred shares have better dividend than the market interest rate, then the company can pay off by buying them back and issues another one whose dividend rate is lower.

• Term - Many preferred shares are perpetual preferred stock. This has no maturity date.
• Holding a perpetual preferred share with a low yield will almost always end poorly for the investor. The value will never return to its face value, therefore it will most likely continue to trade on the market well below its issuing price.
• Callable - Almost all preferred shares are callable. If interest rates drop, you can expect your shares to be called, and your market price growth to disappear.
• Most preferred shares have an adjustable dividend rate. An adjustable-rate preferred stock (ARPS) pays a dividend that is tied to a current interest rate benchmark, such as the US Treasury. However, the interest rate usually has ceiling and a floor.

Summary

1. Read the Certificate of Designation
2. Buy cumulative preferred
3. Avoid perpetual terms
4. Beware of callable Securities