How Preferred Shares Work

Preferred SharesPreferred shares are yet another way of earning income from your investment and diversifying your portfolio. I started discussing it briefly in my recent weekly dividend round to touch on the point that Apple has been discussing the offering. Just recently, PWF issued preferred shares. Here is the snippet I got from my discount broker:

  • Power Financial Corporation 4.80% Non-Cumulative Perpetual Preferred Shares
  • Short Description: Treasury Offering of Non-Cumulative First Perpetual Preferred Shares, Series S
  • Price: $25.00 CDN per share.
  • Settlement: February 28, 2013.

Great offerings don’t last very long! Those shares were gone in a matter of hours. My friend, the Dividend Ninja, happened to snap some and shared his purchase on his blog.

Preferred Shares versus Common Shares

As the name implies, “preferred” shares offer investors certain advantages while also limiting the earning potential compared with common shares. Generally, preferred shares represent an investor’s ownership stake in a company. More specifically, they represent a claim on its earnings and assets.

Here are some unique comparison points:

  • Preferred shares, like common shares, can be bought and sold by a discount broker.
  • Preferred shares do not have voting rights.
  • Preferred shares do have priority when dealing with dividends and bankruptcy.
  • Preferred shares pay a fixed dividend set up front.

Perhaps the most striking difference between the two is the order in which shareholders are paid in the event of corporate restructuring or bankruptcy. The owners of preferred shares are prioritized over common shareholders when it comes to liquidating a bankrupt company’s assets and paying dividends.

Furthermore, the dividends paid on preferred shares are guaranteed to be fixed on a regular basis. On the other hand, the dividends paid on common shares can fluctuate intermittently. This way preferred stock works the same way as bonds.

Preferred shares come in a number of varieties which makes their terms and structures very flexible. The most common in the financial market are –

Types of Preferred Shares

Rate Resets

Rate reset preferred shareholders agree to pay a fixed rate for the first five years before they recalibrate. In this way, they differ from typical preferred rates which pay fixed dividends in perpetuity.

Rate reset shares are more profitable prospects for investors since they come with tax advantages over buying bonds. Such shareholders are taxed at preferential rates over interest payments even though the dividends are fixed like bond coupons.

Perpetual Preferred Shares

Perpetual preferred shares have no maturity date. Issuers of this type of shares will always be entitled to redemption privileges. Issued perpetual preferred shares will also keep paying dividends on an indefinite basis.

Since such shares do not have a maturity date it means that an investment can remain in effect until the holder decides to liquidate the share. In this way, perpetual shares provide investors investments on a long-term basis.

Investors usually preferred perpetual shares for their longevity and stability. Once an investment has been made, such stock will not be affected if market rates happen to fluctuate. In other words, the share will always pay out the same rate of interest as it was worth when it was first bought. This is also why perpetual shares are so popular with investors who prefer low risk investments.

Floating Rate Retractable

A floating rate retractable shareholder will be entitled to dividends that are based on current market rates. In this way a floating rate preferred comes with a dividend that will be reset during specific intervals. The dividends will be reset according to a predetermined formula set forth in the prospectus.

Also known as variable rate preferred shares, this particular type of share contrasts with other types of preferred shares since the latter pays fixed quarterly dividends. In the case of floating rate shares the dividends are adjusted automatically in order to keep shares selling near to pay. This is also why these shares do not usually fluctuate.

Retractable Preferred Shares

A retractable preferred share would allow its owner to sell it back to the issuer at a fixed rate. An issuer can usually force the redemption of retractable shares for cash at maturity. Retractable shares can also be exchanged for common shares instead of cash when specified.

Retractable preferred shares are similar to fixed bonds in this way. However, they pay dividends instead of interest. Furthermore, being retractable also means that these types of shares will remain steady above or par value. This makes them different from traditional preferred shares that fluctuate with changing interest rates.

More types of preferred shares exist but those mentioned are the most popular. Make sure you sign up with your discount broker to be notified of new offering. Before closing, take a minute to answer the poll below.

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Image courtesy of David Castillo Dominici - FreeDigitalPhotos.net

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