People with investment portfolios are generally familiar with the main asset classes such as cash, bonds, equities or real estate. They are not always aware, however, that each class comprises various subclasses with distinct features. In the equity asset class, preferred shares form one of these subclasses.
Like the securities known as “common” shares, preferred shares are issued by companies in order to raise the capital they need. However, they differ from common shares in three main ways:
- they do not give voting rights to shareholders, who thus have no influence over the company’s strategic orientation – the choice of directors, for example – at the annual shareholders’ meetings;
- on the other hand, they do have priority when it comes to corporate earnings, which means that the dividends payable on preferred shares take precedence over those on common shares;
- in the event of bankruptcy and the liquidation of corporate assets, preferred shareholders are paid before common shareholders (although not before creditors and bondholders).
Shares with a “fixed income” personality
Because of their emphasis on dividend income that, in principle, is more “guaranteed” than for common shares, preferred shares are often thought of as halfway between common shares and fixed income securities like bonds. Investors who add preferred shares to their portfolios don’t want to completely give up the possibility of capital growth typical of common shares, but they hope for predictability similar to fixed income securities when it comes to investment income. As well, preferred shares are generally less volatile – but also less liquid – than common shares.
It’s worth pointing out, as well, that this type of investment offers a tax advantage over bonds in that, instead of interest, preferred shares pay dividends, which are not as heavily taxed. Finally, while for a bond a higher yield is often indicative of a higher credit risk, the dividend yield on preferred shares actually tends to reflect the company’s ability to pay its shareholders, and thus its financial health.
Twofold potential, twofold risk
While preferred shares offer some of the attractions of both common shares and fixed income securities, they also share some of the risks. For example, the market value of a bond varies with changes in interest rates, falling when the prevailing rates rise and rising when they fall. If the bonds are sold before they mature, this could result in a capital gain or loss. This may also apply to the value of preferred shares. Keep in mind that there are different types of preferred shares, and they may react differently to interest rate fluctuations.
Due to the volatility risk, together with the liquidity risk, preferred shares are not considered to be risk-free investments. Nonetheless, they can find their place in many portfolios, especially within mutual funds fully or partially invested in this asset class in a diversified way.
To assess whether this type of investment has a place in your own portfolio, don’t hesitate to contact your mutual fund representative or financial security advisor.
The following sources were used to prepare this article:
Autorité des marchés financiers, “Shares”.
Get Smarter About Money, “How stocks work”.
Investopedia, “Preferred vs. Common Stock: What’s the Difference?”.
Les affaires, “Le risque des actions privilégiées”.