Preference shares aren't just for governments and billionaires, we show how private investors can buy them too.
The need to get more cash on the balance sheet has forced many corporate giants to 're-capitalise', but what do the following deals have in common?
- Warren Buffett's investment of $5bn in Goldman Sachs (NYSE: GS);
- Wednesday's announcement that Ireland's national pension fund will invest €7bn in Allied Irish Banks (LSE: ALBK) and Bank of Ireland (LSE: BKIR);
- British taxpayers' investment in banks such as Lloyds Banking Group (LSE: LLOY).
The answer is that the investors received preference shares, or 'preferred stock' as it's called in the US, for all or part of the deal. But how is this different from the ordinary shares that investors usually buy?
A hybrid investment
You can think of preference shares as a hybrid between ordinary shares and corporate bonds.
- Preference shareholders receive a fixed dividend, similar to the interest receivable on a bond (which I've explained in more detail here);
- Unlike bond interest, though, the failure to pay a preference dividend cannot force the company into administration;
- If the business is wound up, and there is any capital left over after paying the various creditors, preference shares are repaid before ordinary shares;
- Preference dividends must be paid out before any dividends to ordinary shareholders.
For the investor, prefs are not as risky as ordinary shares, but are riskier than bonds. Conversely, for the company, paying preference dividends is more onerous than paying ordinary dividends, but without the imperative of paying interest.
Adding to this burden is the fact that most preference shares are 'cumulative'; this means that any preference dividends not paid will be accrued until funds are available, and must be paid out in full before ordinary shareholders receive anything.
Some preference shares are also 'convertible', meaning that they can be exchanged for ordinary shares at a future date.
Where to find them
So it's easy to see how preference shares fill a niche between ordinary shares and bonds, and how they're attractive to both the company and the investor in certain circumstances. But do you have to be Warren Buffett or Alistair Darling to take advantage of prefs?
Clearly the small investor can't arrange attractive terms, like the big players can, but there are some preference shares traded on the stock exchange, and they're not difficult to buy. They are mostly issued by financial institutions, and as with any investment you'd need to have an opinion on the health and prospects of those companies before buying.
Some typical examples are Lloyds Banking Group 9 1/4% Non-Cum (LSE: LLPC), paying a yield of 16.4%, and General Accident 8 7/8% Cum (LSE: GACA) paying 9.1% -- the yields reflecting the perceived riskiness of the investments. Note that these are net percentages, i.e. after deduction of basic rate income tax. The best list of preference shares that I've found in on the website of Collins Stewart (LSE: CLST).
Because they're such a small part of the market -- much less than 1% of all shares -- unit trusts tend to include them with corporate bonds in some fixed interest funds. The one exception that I'm aware of is Aviva, which has a dedicated fund for prefs, charging 4% initial fees and 1.25% per annum.
Preference shares won't suit everyone, but they're another weapon in your investing arsenal. Don't forget that you can buy both preference shares and ordinary shares for as little as £10 a trade using the Motley Fool Sharedealing Service.
More info: Corporate Bonds
