Preference shares explained

Preference shares have swamped the market. This issue we explain what they are and whether they are worth dipping into.

Preference shares sound very fancy. And why not, if investors think they're getting preferential treatment? But there's a little more to them than an attractive sounding name.

To start, let's look at their basic appeal. There are two key points that separate a preference from an ordinary share. Firstly, if the company happens to go bust preference shareholders can put out their hands for any liquidation proceeds before ordinary shareholders, although they still lag behind secured creditors. In recent corporate collapses, it wouldn't have made much difference.

Secondly, preference shares usually pay a higher dividend (not guaranteed) compared to their ordinary counterparts and again, owners stand further up the queue.

Income-led

In other words, preference shares are all about income and have little to do with capital growth.

Over the past six months preference shares have gained in popularity with companies as different as Santos, Fairfax and Computershare all launching new offers. From the issuer's point of view, preference shares offer the company the opportunity to shore up their balance sheets while interest rates are low.

This form of borrowing also offers greater flexibility in the years to come because, if necessary, it's easier for the issuer to change the terms of preference shares than it is to change the terms of a bank loan, which, as some of you may know, can be all but impossible.

Now what's in it for you, the investor? Well, generally you'll get fully franked dividends at a higher rate than the general market is paying. The rate will almost certainly be higher than what the money markets are offering for similar terms.

This is best illustrated with an example. In November last year Santos offered $100 convertible, non-cumulative, 6.5% fixed dividend or swap rate plus 1.2% (whichever is the greater) paying preference shares until first reset date of September 2006.

What does that mean in English? Convertible means that in April 2006 you'll have the option to convert your $100 preference shares into ordinary stock at the going price with a 5% discount. The swap rate is the floating interest rate.

Income not certain

Non-cumulative means that if Santos doesn't have the cash to pay your dividends in one period, it's not obligated to make them up next payment period. Obviously, this favours the company. The reset date is the official time for either the company or shareholder may convert to ordinary shares.

So, if you just want income from shares then preference shares are well worth considering, especially if they are fully franked. But don't forget that you're still taking risks because the income is not guaranteed and your capital can depreciate before the reset date – just like a bond (please see our Computershare example to the left). That's not good if you have to sell early.

And always bear in mind that a strong case can usually be put forward to stick with ordinary shares, particularly if they're already paying a healthy dividend with the potential bonus of capital gains too.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Join the Conversation...

There are comments posted so far.

If you'd like to join this conversation, please login or sign up here

Related Articles