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I have heard several people compare preferreds to bonds or to even fixed deposits, but that is a gravely mistaken way of looking at it, since the risks are higher (in some cases, much higher).
Disclosure: I do not hold any preferred stock of any firm.
Introduction
At launch, preferreds typically promises a particular yield in relation to its offer price. For example, Brown Company might offer a preferred at a price of 100 with a yield of 6% during the IPO of this preferred shares. This simply means that a dividend of $6 would be paid out per year in total, if all remains well at the company. These payments might happen at specific intervals like quarterly or annually. The intended use of the funds raised from the offerings of the preferred are usually described in its prospectus during the IPO stage, and preferreds then trade on the open market. The funds can be used for its operations or expansions and in this respect is not unlike any other securities offering of the company. Other types of securities offerings by a listed company can be a shares offering, or a debt offering. A shares offering involves releasing more shares of the firm (leading to a dilution of existing shareholders), while a debt offering involves selling a bond to the public, where the bondholders are essentially creditors of the firm.
Seniority
A preferred ranks above common shares, but below bonds, or we can say that preferred are senior to shares, in terms of its rights and claims, but junior to bonds. What this means is, in the case that the company goes bankrupt, bondholders get the first claim to the assets, or the proceeds from the sales of these assets, of the firm. Once all bondholders are paid, then comes the holders of preferred stock, and after all claims from the preferred holders are met, the shareholders can lay a claim on the remaining assets, if there are any left.
However, the dividend while reasonably secure is NOT guaranteed. If the company’s operations encounter difficulties or if there is say, an economic downturn, they could, to conserve their capital, not pay out the dividend due that year.
Not all preferreds are the same: Privileges
While preferreds tend to be referred to as if the entire class was homogenous, they are in fact not. Some preferreds have certain privileges such as
Cumulative: if the dividends for the year are not paid, then it accumulates and would be paid subsequently when the dividends are resumed.
Convertibility: some preferreds can be converted to common stock at a specified conversion rate. This then to lead to dilution of existing shareholders.
Voting: some preferreds give voting rights, which means that preferred holders could vote out the current management, or against certain actions that they deem detrimental to holders of this class of securities. This could be important since shareholders might for example want the firm to expand rapidly, while bondholders might rather the firm not expand at all since expansion comes with risks. Different class of security holders for the same firm might have different and at times, conflicting, interests.
Some preferreds do not have any of these privileges. The value of such privileges needs to be factored into the price of the offering. Some of the value of these privileges are debatable while some can indeed be valuable, depending on the market situation during the life of the security. Some preferreds are perpetual (meaning they are meant remain in the market forever) while some can be called or bought back after a pre-defined time.
A Hybrid (and I don't mean a car that runs on electricity)
An important aspect for a prospective investor to consider is as usual, what is his investment objective. A preferred is a hybrid security – it has the cash flows of a bond, with its regular promised payouts, but unlike the bond, the firm could withhold these payments, and it could take this decision unilaterally, without consulting the preferred holders.
For a bond, the firm would have to negotiate with its bondholders if it wanted to not pay or delay a particular coupon. In fact, the premise of bonds is that coupons MUST be paid at its specified time, regardless of how well or badly the company’s operations are doing. Hence bonds have the highest level of assurance of any of the firm’s classes of securities. (Do note that within the bonds class, there are also senior and junior debt tranches.)
If the company does well, the preferred holder enjoys his regular dividends, which will NOT increase. Say an investor had purchased Brown’s preferred at its IPO, at a price of 100 and yielding 6%. If the company thrives, and becomes the best company in the world, the investor enjoys his 6% but NOTHING more. (To be exact, the price of the preferred might also rise, but this tends more to do with the interest rate environment than the company’s performance. Why? Because no matter how well the company does, the yield remains $6 per preferred while the dividends on the common stock might increase to whatever heights).
Let’s contrast this to the holder of common shares of Brown. If the company thrives and does exceptionally well, the common shares of Brown would likewise do well, and the shareholders might enjoy great profits from the rising price of Brown’s shares.
If the company does badly, it would first cut the dividends of its shareholders. If it decides it needs to further conserve capital, the next to go would be the preferred’s dividend. At no point does it go and cut the coupons of the bondholders, since that constitutes a default and the bondholders typically have certain protections, for example they can then force the company to repay the entire debt straight away, or sell its assets to make good the amount owed.
Naturally, once the company cuts the dividends of the shareholders, the common stock’s value would be impacted. It would then call into question how assured is the preferred holder’s dividends, which is next to be cut. This could cause the preferred share price to also fall, since there is now doubt over the continuance of the dividend.
What I am pointing out is, preferred enjoys none of the upside of a company’s success. What they do get from a successful company is the continuance of their dividends but nothing more. They also do not enjoy the assurance of the bond holders, who regardless of whether the company is doing well or not, gets their coupons and return of principal upon expiration of the bond.
The downside: they face the risks of the shareholders when the company does badly, while they do not enjoy the protection of the bondholders. The upside: They get their fixed dividends while the shareholders enjoy both the dividends (which could be increased) and the rise in share prices. The bondholders still get their coupons.
So during good times for the company, the preferred is like a bond, but during bad times, the preferred is like a share. Or the worst of both worlds.
Valuing a preferred
The value of a preferred depends on the costs of financing in the market. It can be thought of as the current yield of its bond plus a spread to compensate for the abovementioned risks. What this spread should be is to compare with other preferreds of other firms of comparable risks, to determine if this spread is fairly priced. However, the corporate securities market is shallow in Singapore, and there might be insufficient information to make these calculations.
The risk factors that affect bonds would also affect the preferred. One important factor is the interest rate environment. If interest rates rise, bond prices fall. Why? Consider a 10 year Brown Company’s bond (let’s call it BrownBond) currently priced at 100 with a yield of 4%. Say the yield of a government bond (or GBondA) (with 10 years left to maturity) to be 2%. There is a 2% or 200 basis point spread, which covers the extra risks of the firm versus the government’s bond. (Spread = yield of company’s bond – risk free rate)
If a new government 10 year bond (GBondB) is now launched at 3%, why would anyone buy GBondA with its poorer yield when they can take on the same risks and get GBondB and earn 1% more? Hence the price of GBondA would have to fall, until the yield of GBondA and GBondB becomes the same.
To help the reader, yield = dividends and other cashflows each year / amount invested. For investors in Brown Preferred, yield = $6 of dividends / $100 which is the cost of 1 share of the preferred = 6%.
If the spread of Brown’s bond remains constant (there are factors affecting spreads, for example if Brown’s credit worthiness deteriorates, but let’s assume those to be constant), then Brown’s bond value also must fall.
And remember how the bond value and the preferred value are related? The yield on the preferred also now seem less attractive since interest rates have risen and newly launched preferreds or other fixed income instruments now appear more attractive. Hence the value of the preferred could fall, to compensate. Likewise in a decreasing interest rate environment, the value of preferred would rise. (So, considering that interest rates in Singapore are approximating zero, how much more do you think it would go down?)
This short piece on preferreds is just meant to give you some points to think about if you are considering such an investment. It is certainly not comprehensive, but I wanted to dispel some notions on the safety of preferreds and also list some points that you should consider. Do find out more. Just like in any investments, not all are good, BUT not all are bad either. Investing in the right preferreds at the right time can be highly profitable. The wrong preferred at the wrong time can be disastrous. You have to consider what your objectives are, and whether the instrument you choose helps you meet that objective BOTH in terms of its returns and its risks, on a portfolio basis.
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