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Why are Preferred Shares called ¡§preferred'?
Explain why some portfolio managers consider them more like a fixed income product than an equity security.
Describe a situation wherein an investor in preferred shares might enjoy capital appreciation from his/her investments.
Why are Preferred Shares called ¡§preferred'?
Preferred shares are called 'preferred' because they give preferential treatment to the shareholder with regards to dividend payouts and asset allocation priority in the event of the company's dissolution.These characteristics are known as the preference as to assets, and the preference as to dividends clauses built into every preferred share.Secondly, I would also imagine that this name was given to the product, because of the advantageous position the company sometimes takes when they issue these shares, thus making the company prefer to issue these shares over bonds and sometimes common shares.
Unlike bonds, the company is not legally obligated to pay out dividends, and thus can use these products to their great benefit when times are tough.Also, unlike common shareholders, preferred shareholders do not generally have any voting rights ¡V unless the company misses 6 or more consecutive quarterly dividend payouts ¡V which again benefit the company because this gives the Board of Directors the chance to run the company the way they see fit.
Explain why some portfolio managers consider them more like a fixed income product than an equity security.
The key factor which endorses this popular viewpoint is that preferred shares offer a fixed dividend payment.This, of course, is not an official notion, because preferred shares represent ownership in a corporation and thus have to be grouped along with other 'equity' securities.Unlike common shares, preferred shares generally do not participate in the companys growth. The dividend is typically decided upon at the time of the offering and remains fixed until maturity, or until the shares are sold back to the company.
The company does not have to uphold the dividends as a legal requirement, similar to interest payments on bonds.If the companys directors decide to skip the payment of a preferred share dividend, there is little the preferred shareholder can do about it.As a general rule of thumb, the common shareholders would not receive any dividends at all until the preferred shareholders are given what they are entitled too.In most cases, the preferred shares will come with a clause stating that an 'arrears' will be created to fund any missed dividend payments for the preferred shareholders.
The other major reason why preferred shares are considered to be fixed-income investments is because their value tends to be influenced by changes in interest rates, much like fixed-income securities such as bonds. A fall in interest rates will tend to boost the value of bonds and preferred shares due to the shorthanded rates given to the newer issues, and vice-versa.
Although preferred shares do not offer the same potential for capital growth as common shares, they usually pay a much higher dividend that does not fluctuate. For these reasons, preferred shares are very attractive to conservative, income-oriented investors.
Describe a situation wherein an investor in preferred shares might enjoy capital appreciation from his/her investments.
Considering that a preferred share is a hybrid security, having some of the characteristics of a common share and some characteristics of a bond, it is safe to assume that under certain conditions the shareholder can expect capital gains over and above his preset dividend.
The first situation which could produce a capital gain for a preferred shareholder is if his/her shares have the 'Convertible' feature.These 'convertible' preferred shares allow the investor to convert the preferred shares into some other class of shares, usually the company's common shares at a fixed price within a specified period.Generally, the company will set the preferred share issue price at a slight premium to the conversion value, and also include a timeframe in which the shareholder is not allowed to convert the preferred share.The capital gain happens when
Ex
„XABC Company Series A preferred shares are convertible into 1. common shares after the holding period of 1 year.
„XOn April 15th 001, ABC common shares were trading at $17.5.At this price the preferred shares are worth at least $0.75 ($17.5 x 1.).On April 15th 001 the preferred shares are selling for $ (slight premium on the calculated value of $0.75).
„XBy April 15th 00 (when the holding period is over), the common shares have risen in price by 15% to $1.84.
„XIf the shareholder decides to convert the preferred shares into common shares at the pre-stated ratio of 11. his common shares will now be worth $.81 ($1.84 x 1.).
„XHenceforth, the shareholder will earn a capital gain of $1.81 per share ($.81 - $).
The second scenario, in which preferred shareholders can earn capital gains, is if the shares come with a 'participating' feature.This gives the shareholder a certain share of the company's net profits over and above the specified dividend rate.
The last feature which could lead to a capital gain on a preferred share is called 'redeemable'.This clause allows the company to redeem the shares within a specified time period.When the shares are redeemed, the holder of the preferred shares receives a premium on the par value of the shares thus creating a capital gain.
In conclusion, preferred shares can be a very interesting product for people, whom desire steady income from their investments and are willing to take on a little more risk than with a product such as a GIC.The key to selecting these shares ¡V much like anything else in the markets ¡V is to do your homework and understand every feature which comes with the issue; and, weigh those features against the current interest rates, the company's credibility and the issue price.
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