Introduction

Investors looking for stable returns often consider preference shares as an investment option. But what is a preference share? Simply put, preference shares in India (also known as preferred stock) are a type of equity security that offers fixed preferred dividends before any dividends are distributed to equity shareholders. These shares strike a balance between equity and debt instruments, making them a preferred choice for risk-averse investors.

Unlike equity shareholders, preference shareholders have limited voting rights, but they enjoy priority when it comes to dividend payments and repayment in case of liquidation. Companies issue preference shares to raise preference share capital while offering investors a fixed-income-like return without diluting control.

In this blog, we will explore the types of preference shares in India, their features, benefits, and costs associated with investing in them.

Understanding Preference Shares

What is Preference Share?

A preference share is a type of share that provides its holders with preferential treatment in terms of dividend payments and asset distribution in case of liquidation. It is a hybrid security that exhibits characteristics of both equity and debt. Unlike common shares, preference shares offer stability and predictable returns, making them attractive to investors who prioritize security over high volatility.

How Preference Shareholders Differ from Equity Shareholders

• Priority in Dividends: Preference shareholders receive dividends before equity shareholders, ensuring a steady income stream for investors.
• Fixed Returns: Preferred dividends are usually at a fixed rate, providing more predictable income compared to the fluctuating dividends of common shares.
• Limited Voting Rights: Unlike equity shareholders, preference shareholders typically have no or limited voting rights in corporate decisions. However, in cases where dividends remain unpaid for an extended period, certain types of preference shareholders may gain voting rights.
• Lower Risk: Preference shares are less risky compared to common stock due to their fixed return nature. They act as a middle ground between equity and debt instruments, offering more security than equity but less than bonds.
• Conversion Flexibility: Certain convertible preference shares allow holders to convert them into common shares after a predetermined period, offering capital appreciation potential along with dividend stability.

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Types of Preference Shares in India

There are several types of preference shares in India, each catering to different investor needs. Let’s explore the major types:

1. Cumulative Preference Shares

Cumulative preference shares come with a unique feature if the company is unable to pay dividends in a particular year due to financial constraints, the unpaid dividends accumulate and must be paid before any dividends are given to equity shareholders. This makes them a preferred choice for investors seeking guaranteed dividend payouts over time.

2. Non-Cumulative Preference Shares

Unlike cumulative preference shares in India, non-cumulative preference shares do not carry forward unpaid dividends. If a company does not declare a dividend for a particular year, preference shareholders forfeit their dividend entitlement for that period. These shares are suitable for investors comfortable with market risks but still seeking a priority in dividend distribution.

3. Redeemable Preference Shares

Redeemable preference shares have a pre-determined redemption period, meaning the issuing company is obligated to buy them back after a specified period or upon fulfilling certain conditions. These shares provide flexibility to companies in managing their capital structure while giving investors an exit strategy.

4. Irredeemable Preference Shares

Unlike redeemable preference shares in India, irredeemable preference shares do not have a specified maturity date. These shares remain in circulation indefinitely unless the company voluntarily repurchases them. They offer perpetual fixed dividends, making them ideal for investors seeking long-term income streams.

5. Convertible Preference Shares

Convertible preference shares come with an option to convert them into equity shares after a specific period. This allows investors to initially enjoy fixed dividends and later benefit from the capital appreciation of common shares. They are a popular choice for investors who seek a balance between income and long-term growth potential.

6. Non-Convertible Preference Shares

As the name suggests, non-convertible preference shares do not offer the option to convert into equity shares. Investors holding these shares will continue to receive fixed dividends without the opportunity for capital appreciation. These shares are more suitable for conservative investors focused on income rather than stock market fluctuations.

7. Participating and Non-Participating Preference Shares

• Participating Preference Shares: These shares provide shareholders with an additional share in the company’s profits beyond the fixed dividend rate. If the company performs exceptionally well, holders of participating preference shares may receive extra dividends along with their fixed payouts.
• Non-Participating Preference Shares: These shares only entitle shareholders to a fixed dividend and do not allow them to participate in additional earnings. Investors opting for these shares prioritize fixed returns over potential profit-sharing opportunities.

Issue of Preference Shares

Companies issue preference shares through various methods to raise capital. The key aspects of the issue of preference shares in India include:

Process of Issuing Preference Shares

1. Board Approval: The company’s board of directors must approve the issuance, ensuring it aligns with corporate goals and shareholder interests.
2. Regulatory Compliance: Companies must comply with legal requirements set by regulatory bodies like SEBI, ensuring transparency and investor protection.
3. Offer Document: A prospectus outlining details such as dividend rate, redemption terms, and conversion options is shared with potential investors.
4. Public or Private Placement: Companies can issue preference shares through public offerings or private placements to institutional investors, depending on their funding requirements.
5. Pricing and Allotment: The shares are priced based on factors such as interest rates, company creditworthiness, and market conditions before being allotted to investors.

Key Considerations for Investors

Dividend Yield:

One of the main attractions of preference shares is their fixed dividend payout. Unlike common stocks, where dividends are not guaranteed, preference shares in India offer a fixed dividend rate, providing a stable income stream. However, this stability often comes at a trade-off:

• The fixed dividend yield on preference shares may be lower than the potential returns from common stocks, especially during periods of strong market performance.
• While preference shares provide consistent income, they may not offer the same level of capital appreciation as common shares, which can experience significant price growth over time.

For example, if a company’s common stock price rises by 20% in a year, preference shareholders will only benefit from their fixed dividend payout, missing out on the capital gains enjoyed by common shareholders.

Liquidity:

Liquidity refers to how easily an asset can be bought or sold in the market without significantly affecting its price. Preference shares are generally less liquid than common stocks for several reasons:

• Fewer investors may be interested in preference shares compared to common stocks, leading to lower trading volumes.
• This reduced market activity can result in wider bid-ask spreads, making it harder to execute trades at favorable prices.
• Investors who require quick access to cash might face challenges when selling preference shares, especially during periods of market stress.

Thus, investors should assess their liquidity needs and market conditions before investing in preference shares in India.

Risk Profile:

The risk associated with preference shares varies depending on their structure:

• Redeemable Preference Shares – These shares provide added security because the company commits to repurchasing them at a specified date or price. This reduces the investor’s exposure to market volatility and provides a clear exit strategy.
• Cumulative Preference Shares – If the company misses a dividend payment, the obligation to pay dividends accumulates. This means that before any dividends are paid to common shareholders, the company must first settle the arrears owed to cumulative preference shareholders. This ensures a higher level of income security.
• Non-cumulative Preference Shares – These shares do not accumulate missed dividends, which means if the company skips a dividend payment, the investor permanently loses that income.

Investors with a lower risk tolerance may prefer cumulative or redeemable preference shares for their added income security and predictable exit options.

Conversion Rights:

Convertible preference shares in India provide an option for investors to convert their preference shares into common shares at a predetermined price and time. This feature makes them particularly attractive for long-term investors because:

• If the company’s stock price rises significantly, convertible preference shareholders can participate in the upside by converting their shares into common stock.
• This allows investors to benefit from both fixed income (through dividends) and potential capital appreciation.
• However, conversion terms (such as the conversion ratio and price) should be carefully reviewed to assess the potential upside.

For instance, if a convertible preference share allows conversion into common stock at ₹100 per share and the stock price rises to ₹150, the investor benefits from both the dividend income and the capital gain upon conversion.

Redemption Terms:

Investors should check whether the preference shares are redeemable or irredeemable, as this affects the flexibility and exit strategy of the investment:

• Redeemable Preference Shares – The company has the right (or obligation) to buy back the shares at a predetermined date or price. This gives investors greater clarity on their capital recovery but may limit long-term upside potential.
• Irredeemable Preference Shares – These do not have a maturity date, meaning investors can hold them indefinitely or sell them in the market. While this offers greater long-term flexibility, it exposes investors to the risk of market fluctuations.

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Cost of Preference Shares

Investing in preference shares comes with associated costs that both investors and issuing companies should consider.

How Cost is Determined

The cost of preference shares is typically calculated as:

Cost of Preference Shares = (Preferred Dividend / Market Price)

Example:

Let’s assume a company issues preference shares with the following details:

• Preferred Dividend: ₹50 per share per year
• Market Price: ₹1,000 per share

Now, to calculate the cost of preference shares, we use the formula:

Cost of Preference Shares = (Preferred Dividend / Market Price)

Substituting the values:

Cost of Preference Shares = 50 / 1000 = 0.05 or 5%

Interpretation:

In this example, the cost of preference shares is 5%. This means that for every ₹1,000 invested in preference shares, the investor will receive ₹50 annually as a fixed dividend.

• If the market price decreases (e.g., to ₹900 per share), the cost of preference shares would increase to:

50 / 900 = 0.0556 or 5.56%

• If the market price increases (e.g., to ₹1,200 per share), the cost of preference shares would decrease to:

50 / 1200 = 0.0417 or 4.17%

So, the cost of preference shares is directly influenced by the market price, and a lower market price generally makes the preference shares more attractive for investors as they provide a higher yield (dividend relative to the price paid).

The higher the dividend and lower the market price, the more attractive the return for investors.

Factors Affecting the Cost of Preferred Stocks

1. Dividend Rate

The dividend rate directly influences the cost of preference shares for issuing companies. Higher dividend rates mean greater payouts, increasing the financial burden on the company. Companies issuing redeemable preference shares with high dividends must ensure they generate enough profit to meet these obligations. Investors should assess whether the offered dividend is competitive based on market conditions and the company’s financial health.

2. Market Conditions

Economic factors such as interest rates, inflation, and overall demand for preferred stock affect its pricing. When interest rates rise, the attractiveness of fixed-income instruments like preferred stock decreases, potentially lowering their market price. Conversely, in a low-interest-rate environment, preference shares become more desirable, driving up their price.

3. Redemption Terms

Redeemable preference shares have different pricing structures compared to irredeemable preference shares. Investors prefer redeemable shares if they have a clear exit strategy, but these shares may carry slightly lower dividend rates due to their predefined maturity. Irredeemable preference shares, on the other hand, often come with higher dividends to compensate for the lack of a redemption feature.

4. Conversion Benefits

Convertible preference shares may offer lower dividend rates than non-convertible preference shares because they provide the added benefit of conversion into common equity. If the company’s stock performs well, investors can convert their preference shares into equity, potentially gaining higher returns. This conversion feature reduces the risk for investors but may increase the issuing company’s long-term costs due to the potential dilution of equity.

Advantages and Disadvantages of Preference Shares

Advantages

1. Fixed Income: Investors enjoy regular preferred dividends, ensuring a steady stream of passive income. This is particularly attractive for retirees or conservative investors who prefer stability over volatility.
2. Lower Risk: Compared to equity shares, preference shares carry a lower risk due to their priority in dividend payments and asset distribution in case of liquidation. This makes them a safer investment option for those looking to avoid market fluctuations.
3. Capital Flexibility for Companies: Companies can issue redeemable preference shares to efficiently manage their capital structure. By redeeming shares when convenient, they can maintain financial stability and adapt to changing market conditions.
4. Equity Upside with Convertible Preference Shares: Convertible preference shares offer the opportunity to convert into common stock, providing investors with the potential for capital appreciation if the company’s equity value rises. This feature makes them appealing to investors who want a mix of fixed income and growth potential.
5. Attractive to Institutional Investors: Many institutional investors and mutual funds prefer investing in preference shares due to their predictable returns and relatively lower risk.
6. No Obligation for Additional Profit Sharing: Unlike common shareholders, preference shareholders receive a fixed dividend and do not participate in additional profit sharing (unless they hold participating preference shares), making it easier for companies to forecast dividend obligations.

Disadvantages

1. Limited Growth Potential: The fixed dividend structure of preference shares means that investors miss out on high equity returns when the company performs exceptionally well. Unlike equity shareholders, they do not benefit from rising stock prices unless their shares are convertible.
2. Liquidity Issues: Preference shares are not as actively traded as common stock, which can make it challenging for investors to sell their holdings quickly at a desirable price. This lower liquidity can be a drawback for investors who may need immediate access to their funds.
3. Limited Control and Voting Rights: Preference shareholders generally have no voting rights or very limited influence in corporate decisions. This makes them passive investors with little say in governance and strategic direction.
4. Redemption Uncertainty: Irredeemable preference shares remain in circulation indefinitely, which may create uncertainty for both investors and issuing companies. Unlike redeemable preference shares, there is no predetermined exit strategy.
5. Vulnerability to Interest Rate Changes: Preference share capital may be negatively impacted by rising interest rates, as higher bond yields can make preference shares less attractive to investors.
6. Tax Considerations: In some cases, preferred dividends may be taxed at a higher rate than capital gains, making them less tax-efficient compared to long-term equity investments.

Conclusion

Preference shares provide a unique blend of equity and debt benefits, making them an attractive investment option for risk-averse investors. From redeemable preference shares offering exit options to convertible preference shares providing equity participation, the diverse types cater to varying investor preferences.

Jainam Broking Ltd. helps investors navigate the complexities of preference share capital, ensuring they make informed decisions aligned with their financial goals. With expert insights and tailored solutions, investors can optimize their portfolios by choosing the right preference share options. Whether you’re seeking stable income through preferred dividends or long-term equity exposure, Jainam Broking Ltd. provides the guidance needed for successful investing.

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