What Are Preferred Shares in Simple Terms?

What Are Preferred Shares?

Preference shares or preferred stocks are hybrid financial instruments issued by companies to raise capital. As the name implies, holders of these shares enjoy specific “preferential” rights over ordinary shareholders.

The most distinct advantage is the priority in dividend distribution. When a company announces profits, it must pay the fixed dividend rate to preferred stockholders before distributing a single rupee to holders of equity shares. Furthermore, if the company goes bankrupt or faces liquidation, preference shareholders have a claim on assets that ranks higher than equity holders, though still below secured creditors and bondholders.

Key Features of Preference Shares

Understanding the mechanics of these shares is crucial before adding them to your demat account. In the Indian context, they operate with specific rules:

1. Fixed Dividends

Unlike common stock where payouts fluctuate with profits, preferred stocks usually carry a fixed rate (e.g., 10% Cumulative Preference Share).

2. No Voting Rights

Generally, these investors cannot vote on company resolutions at the Annual General Meeting (AGM). However, under the Indian Companies Act, 2013, if dividends remain unpaid for two years or more, preference shareholders gain voting rights on all resolutions.

3. Preferential Asset Claim

In a winding-up scenario, capital repayment is prioritized over equity owners.

4. Callable Nature

Most preferred stocks come with a call option, allowing the issuer to buy them back at a specific price after a set period.

Types of Preference Shares

Indian corporate law allows for various structures of preferred stocks to meet different capital needs.

1. Cumulative Preference Shares

If a company faces a loss and skips a dividend, cumulative shares allow unpaid dividends to accumulate as arrears which must be paid later. In contrast, non-cumulative shares forfeit any dividend not declared in that specific year; there is no accumulation.

2. Redeemable Preference Shares

These shares have a definite maturity period. The company repays the principal amount to the investor at the end of the term.

3. Convertible Preference Shares

These offer a route to ownership. After a set period, the investor can convert these shares into equity shares, potentially benefiting from stock price appreciation.

4. Participating Preference Shares

Beyond the fixed dividend, these shareholders have a right to participate in surplus profits remaining after all other dividends have been paid.

Advantages of Preference Shares

For the retail investor, this asset class offers specific strategic benefits:

• Income Stability: They provide a predictable income stream, making them similar to bonds but often with slightly higher yield potential.
• Lower Risk: These shares are less volatile than equities due to their superior asset claims, though they are not completely risk-free.
• Hedge Against Inflation: Participating preferred stocks can offer returns that scale with company profits, providing a partial hedge that fixed bonds cannot offer.

If you wonder about how preference shares and equity shares differences or what to should, explore more on our source website to learn more insight.

Source: Preference Shares vs Equity Shares