Preference Shares: Explained

In the world of trading, understanding the intricate details of various financial instruments is crucial. One such instrument is the 'Preference Share', a type of share which carries certain privileges that are not enjoyed by the holders of common shares. In this glossary entry, we delve deep into the concept of preference shares, their types, benefits, drawbacks, and their role in trading.

Preference shares, also known as preferred shares, preferred stock, or just 'prefs', are shares in a company that have a fixed dividend, with a payout that comes before dividends for common shareholders. They are a hybrid type of security that possess characteristics of both bonds and common shares. Let's break down this complex concept into simpler, more digestible sections.

Understanding Preference Shares

Preference shares are a unique type of equity in a company. They are called 'preference' or 'preferred' because in case of liquidation of the company, preference shareholders are paid before ordinary shareholders. However, they are paid after the company's creditors. This gives them a higher claim on the company's earnings and assets.

Preference shares typically pay a fixed dividend, unlike common shares where dividends can fluctuate based on the company's profitability. This makes them an attractive investment for individuals seeking a steady income stream. However, preference shareholders usually do not have voting rights in the company, unlike common shareholders.

Features of Preference Shares

Preference shares come with several defining features. The most prominent feature is the preferential right to receive dividends. This means that the company must pay dividends to preference shareholders before they can distribute any dividends to common shareholders. The rate of dividend is either fixed or linked to a benchmark interest rate.

Another key feature of preference shares is the preferential right to return of capital. In the event of liquidation, preference shareholders have a higher claim on the company's assets and earnings than common shareholders. However, they are still behind creditors and bondholders in the pecking order. This feature provides an additional layer of security to preference shareholders.

Types of Preference Shares

There are several types of preference shares, each with its own set of characteristics and benefits. The most common types include cumulative preference shares, non-cumulative preference shares, participating preference shares, convertible preference shares, and redeemable preference shares.

Cumulative preference shares have a provision that allows for the accumulation of unpaid dividends. If the company is unable to pay the dividend in a particular year, the unpaid dividends are carried forward to the next years. Non-cumulative preference shares, on the other hand, do not carry this provision.

Role of Preference Shares in Trading

Preference shares play a significant role in trading. They offer a unique combination of features that can be attractive to certain types of investors. For traders looking for a steady income stream and a higher degree of security than common shares, preference shares can be an ideal choice.

Preference shares can also be used for hedging purposes. Since they have characteristics of both equity and debt, they can provide a balance in a diversified portfolio. They can also be used to speculate on the future movements of interest rates, as the price of preference shares tends to move inversely with interest rates.

Benefits of Trading Preference Shares

Trading preference shares comes with several benefits. The most obvious benefit is the steady income stream provided by the fixed dividends. This can be particularly attractive to income-focused investors. Additionally, in the event of liquidation, preference shareholders have a higher claim on the company's assets than common shareholders, providing a degree of capital protection.

Another benefit of trading preference shares is their potential for capital appreciation. While this is not their primary purpose, preference shares can increase in value, providing the opportunity for capital gains. Furthermore, some types of preference shares, such as convertible preference shares, provide the option to convert the shares into common shares, offering the potential for additional upside.

Drawbacks of Trading Preference Shares

While trading preference shares has its benefits, it also comes with certain drawbacks. One of the main drawbacks is the lack of voting rights. Unlike common shareholders, preference shareholders usually do not have a say in the company's decision-making process. This can be a significant disadvantage for investors who want to have a direct influence on the company's direction.

Another drawback is the limited upside potential. While preference shares can provide a steady income stream and a degree of capital protection, they do not offer the same potential for capital appreciation as common shares. In a bull market, common shares can significantly outperform preference shares. Additionally, the fixed dividend can also be a disadvantage in times of high inflation, as it does not keep up with rising prices.

Conclusion

Preference shares are a unique type of equity that offer a blend of features from both bonds and common shares. They provide a steady income stream, a higher claim on the company's assets, and the potential for capital appreciation. However, they also come with certain drawbacks, such as the lack of voting rights and limited upside potential.

Understanding the intricacies of preference shares is crucial for any trader. By comprehending their features, benefits, and drawbacks, traders can make informed decisions and choose the financial instruments that best suit their investment objectives and risk tolerance.

Start Trading Preference Shares with TIOmarkets

Now that you're equipped with the knowledge of preference shares, take the next step in your trading journey with TIOmarkets. Join over 170,000 traders across 170 countries who have chosen our top-rated platform for trading Forex, indices, stocks, commodities, and futures. With access to 300+ instruments across 5 markets and low fees, TIOmarkets is the ideal place to apply your understanding of preference shares and other financial instruments. Enhance your skills further with our comprehensive educational resources and step-by-step guides. Ready to dive into the world of trading? Create a Trading Account today and start your investment journey with confidence.

Risk disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Never deposit more than you are prepared to lose. Professional client’s losses can exceed their deposit. Please see our risk warning policy and seek independent professional advice if you do not fully understand. This information is not directed or intended for distribution to or use by residents of certain countries/jurisdictions including, but not limited to, USA & OFAC. The Company holds the right to alter the aforementioned list of countries at its own discretion.

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Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.