The category of preferred shares which require the carry forward of unpaid dividends are called cumulative preferred shares. In the case of non-cumulative shares, a dividend that is skipped is lost forever.
Thus, while they offer a fixed dividend, they offer holders a share of the profits of the issuing firm in a particular year.
By Sunil K Parameswaran
Preferred shares are a hybrid of debt and equity, and my professor used to call them ‘Ardhanareshwars’. In other words, they are neither fish nor fowl. They are like debt, in the sense that they usually pay a fixed dividend as in bonds, and unlike equity shares. However, if an issuer misses a coupon payment on a bond, it tantamounts to default. On the contrary, if a preferred dividend is missed, usually it is carried forward and paid later.
Till the backlog of dividends is cleared, the company cannot pay a dividend to equity shareholders. The category of preferred shares which require the carry forward of unpaid dividends are called cumulative preferred shares. In the case of non-cumulative shares, a dividend that is skipped is lost forever.
It must be remembered that the word ‘preferred’ arises, because holders are given preference over equity shareholders. It does not mean that investors prefer them. Like equity dividends, preferred dividends are paid out of post-tax profits. Hence, unlike bonds and debentures, such securities do not offer a tax shield to the issuer. Just the way the board of directors is required to meet and approve an equity dividend payment, it is expected to formally approve the preferred dividends prior to their payment.
In addition to plain vanilla preferred shares there are versions with bells and whistles. Callable preferred shares can be redeemed prior to maturity by the issuer. This call option will be exercised if rates decline, so that the issuer can issue fresh stock with a lower rate of dividends. Convertible preferred shares can be converted to shares of equity, just like a convertible bond.
Adjustable Rate Preferred shares or ARPs, as they are called in the US, are similar to floating rate bonds. The dividends on such shares are linked to a benchmark and consequently vary along with it. Participatory preferred shares are preferred shares with a touch of equity. Thus, while they offer a fixed dividend, they offer holders a share of the profits of the issuing firm in a particular year.
In most countries, individual investors do not prefer these securities. In 1986 the Indian finance minister proposed cumulative convertible preferred shares which proved to be a non-starter. From an investor’s standpoint, these are more risky than debt, and do not offer the profit sharing aspect of equity. Also, in countries where it is taxed in the hands of shareholders, it amounts to being taxed twice, because it comes out of the post-tax profits of the issuing company. In the US, a substantial portion of preferred dividends, received by corporate shareholders is tax exempt.
This explains why there is a clientele for them in that country. In the case of plain vanilla preferred shares, price appreciation due to better performance of the issuing entity is muted. This is because, in the event of better performance, the benefits accrue exclusively to the equity shareholders. However, the price of a preferred share fluctuates in the market due to variations in required yields. Like debt securities, if interest rates were to decline, the prices of such shares would rise. However, if interest rates were to rise, the prices of such securities would decline.
The writer is CEO, Tarheel Consultancy Services