When exploring the vast world of investments, preference shares stand out as a unique financial instrument offering distinct advantages. Also known as preferred stocks, preference shares bridge the gap between equity shares and fixed-income securities like bonds. This blog delves into what preference shares are, their features, types, advantages, disadvantages, and why they might be an appealing option for investors.
What Are Preference Shares?
Preference shares are a type of equity security that gives holders certain preferential rights over ordinary shareholders. The most notable of these is the priority in receiving dividends and claim over the company’s assets in case of liquidation. While preference shareholders usually don’t have voting rights, their fixed returns and safety net make them attractive to conservative investors.
Key Features of Preference Shares
- Fixed Dividend
Preference shares typically offer a fixed dividend rate, which is paid out before any dividends to ordinary shareholders. This ensures a steady income stream for investors. - Priority in Liquidation
In the unfortunate event of a company winding up, preference shareholders have a higher claim on the company’s assets compared to ordinary shareholders, though they rank below creditors. - Limited Voting Rights
Unlike equity shareholders, preference shareholders usually do not have voting rights in general meetings of the company. However, voting rights may be granted in specific circumstances, such as the non-payment of dividends for a certain period. - Convertible or Non-Convertible
Preference shares can be structured to convert into equity shares after a certain period (convertible) or remain as preference shares throughout their tenure (non-convertible). - Redeemable or Irredeemable
Redeemable preference shares can be bought back by the issuing company after a specified period, whereas irredeemable shares remain outstanding indefinitely.
Types of Preference Shares
- Cumulative Preference Shares
These shares allow unpaid dividends to accumulate and be paid out later when the company has sufficient profits. - Non-Cumulative Preference Shares
Dividends not paid in a given year are forfeited and do not accumulate. - Convertible Preference Shares
Shareholders have the option to convert these shares into ordinary equity shares after a predetermined period. - Non-Convertible Preference Shares
These shares cannot be converted into equity shares and remain preference shares throughout. - Participating Preference Shares
Holders are entitled to a share in the surplus profits of the company after paying dividends to equity shareholders. - Non-Participating Preference Shares
These shares provide fixed dividends without any share in the surplus profits. - Redeemable Preference Shares
The company can repurchase these shares after a specified time, providing liquidity to shareholders. - Irredeemable Preference Shares
These shares are not subject to redemption and remain a permanent part of the company’s capital.
Advantages of Preference Shares
- Stable Returns
Preference shareholders enjoy fixed dividends, offering a predictable income stream similar to bonds. - Priority in Payment
Preference shares are less risky than ordinary shares due to priority in dividend payments and asset claims. - Flexible Investment Options
With various types such as convertible and cumulative preference shares, investors can choose instruments that align with their goals. - No Dilution of Control
Since preference shares typically lack voting rights, they don’t dilute the control of existing equity shareholders. - Attractive to Conservative Investors
These shares appeal to investors who prioritize safety and consistent returns over high risk and high rewards.
Disadvantages of Preference Shares
- Limited Upside Potential
Unlike equity shareholders, preference shareholders don’t benefit from the company’s growth, as their returns are fixed. - No Voting Rights
The absence of voting rights limits shareholders’ influence on the company’s decisions. - Lower Liquidity
Preference shares may not be as liquid as equity shares, making it challenging to sell them in secondary markets. - Interest Rate Risk
Fixed returns can become unattractive in a rising interest rate environment, as newer issues may offer better yields. - Tax Implications
In some jurisdictions, dividends from preference shares may not enjoy the same tax benefits as other forms of income.
Preference Shares vs. Equity Shares
Preference shares differ from equity shares in several significant ways. They provide fixed dividends and have priority over equity shares in case of liquidation but lack voting rights and the potential for high returns that come with equity ownership.
Why Invest in Preference Shares?
Investing in preference shares can be a strategic move for individuals seeking stable and relatively low-risk returns. These shares are ideal for investors who prioritize income over capital appreciation. Corporations also use preference shares as a flexible financing tool, allowing them to raise funds without diluting control.
Preference Shares in India
In India, preference shares are governed by the Companies Act, 2013, which sets the framework for their issuance and management. Companies like Tata Motors, Reliance Industries, and ICICI Bank have issued preference shares to raise capital. Indian investors can purchase these shares through the primary market during public issues or from the secondary market.
Wrapping Up
Preference shares offer a unique blend of features from both equity and debt securities, making them an attractive option for risk-averse investors. While they provide stable returns and priority in payments, they lack the growth potential and voting power of equity shares. For companies, preference shares are a flexible way to raise capital without compromising control.
Before investing, it’s essential to evaluate your financial goals, risk tolerance, and the specific terms of the preference shares on offer. With the right strategy, preference shares can be a valuable addition to a diversified investment portfolio.
