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Hybrid Securities Part 3 – Preference shares
Many thanks to Dean Greacen from SMSF Investor for today’s post. Dean will be sharing with us a series of posts on Hybrid Securities, which could be a great investment for SMSFs seeking high yield with capital growth.
A preference share is a type of equity interest which has preferential rights over ordinary shares. The company’s profits are distributed (through the payment of dividends) to preference shareholders before ordinary shareholders. In addition, if the company goes into liquidation, the preference shareholders are paid out before ordinary shareholders, making them slightly less risky to invest in.
Preference shares are legally ‘equity’, and like equity, their dividends are paid out of after tax profits. Investors, however, generally regard preference shares as a form of debt security if:
- there is a contractual obligation of mandatory redemption by the company (a feature of debt rather than equity); and
- the dividend is fixed and cumulative (which is suggestive of fixed interest on a debt instrument).
Preference shares, however, are not pure debt instruments because the payment of the dividend may be dependent upon the profitability of the issuer.
There are a variety of different types of preference shares offered in today’s financial markets with a variety of different characteristics, however, we will only be concentrating on the types of preference shares that are deemed to be the most suitable for the portfolios of SMSF investors. These are:
- Convertible preference shares; and
- Redeemable preference shares.
Convertible Preference Shares
Convertible Preference Shares pay fixed dividends up until a compulsory conversion date, at which time they convert into ordinary shares at a variable price which is determined by the issuing company and is usually at a discount to the prevailing market price. As preference shares, they have priority over ordinary shares in relation to both the payment of dividends and the assets of the company in the case of winding-up.
Generally, a company considering the issue of convertible preference shares is in the position of needing additional equity immediately, but believes that its current share price does not accurately reflect the true value of the company. This might be because the company is currently out of favour with the equity markets. Issuing convertible preference shares offers such a company the opportunity to effectively sell its shares in the future when, they hope, the shares will be worth more in the market. Therefore, from the company’s perspective, the issue of a convertible preference share is a form of delayed equity. The conversion into equity (i.e. ordinary shares), is just held back until the specified date.
From the investor’s point of view, the receipt of fixed dividends up until the time of conversion, which is suggestive of fixed interest, gives the instrument a debt-like quality. Furthermore, the conversion of a preference share to ordinary shares can be thought of as payback of the principle at the end of the term in the form of ordinary shares, and in lieu of cash. The number of shares received is, however, generally determined by prevailing market prices, allowing the investor to participate in share price gains and thus giving the convertible preference share more of an equity flavour.
Redeemable Preference Shares
Redeemable Preference Shares have a fixed redemption date on which they will usually be redeemed at a stipulated price with holders usually entitled to receive payment of the face value of their redeemable preference shares, any premiums on the redeemable preference shares, and any dividends accrued (whether declared or not).
Redemption may be mandatory, at the option of the investor or the option of the issuer. Like convertible preference shares, redeemable preference shares have priority over ordinary shares in relation to the payment of dividends. Whilst their legal form is that of a share (therefore an equity-based instrument), most redeemable preference shares exhibit debt-like features, including:
- fixed dividend payments;
- an option for the holder and/or issuer to redeem the share (or compulsory redemption) for a pre-determined amount; and
- cumulative dividend payments, where any missed dividends must be made up before the company can pay dividends on its ordinary shares.
Redeemable preference shares may be useful in circumstances where ordinary shareholders in a company are seeking temporary use of outside capital for specific projects without risking dilution of their control of the company.
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SMSF Investor is a company that provides expert help to SMSFs. They offer SMSF clients a range of products and services tailored specifically to meet their needs as self managed super fund investors such as a SMSF Investor course and investment advice if needed.
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