What Exactly Are Preference Shares?

Based on the questions received from my previous post on the OCBC preference shares, I think it will be good for me to elaborate more on what preference shares or preferred shares really are.

Preference shares really behave more like a bond than normal shares. Let’s first look at what a normal share is.

A normal share gives you a certain percentage shareholding of a company. You have an economic interest in all future earnings of the company. If there are 100 shares of a company and you own 1 share, effectively you own 1% of the company. If the company is sold, you get 1% of the value. You also get a 1% voting right.

A preferred share is more like a loan to the company. You do not get normal voting rights and to attend AGMs. In return for your capital, you are promised a dividend amount every year. This dividend is not guaranteed and the frequency of payouts will determine on the strength of the company.

This is where a preference share differs from a normal bond. For a bond, the company has to pay the interest no matter what happens. For preference shares, it is conditional upon the company paying dividends to its normal shareholders first. If the company happens to make a loss for that year and decides not to declare any dividends to its normal shareholders, the company can choose not to pay or to reduce the dividends to the owners of its preference shares.

On the other hand, if a company pays out any dividends to its normal shareholders, then it has to fulfill its obligations to its preference shareholders first.

Based on OCBC’s track record, the frequency of dividend payouts should be pretty consistent.

The other difference is that for a bond, it has a fixed maturity date. Come a certain date, you know that you will get back your capital. For preference shares, the company has the right (but not the obligation) to redeem the shares from you on particular dates. If they don’t and you wish to get back your capital, the only way for you is to sell them on the secondary market. The price you get might be lesser or more that what you paid for.

What then affects the market value of the preference shares?

Here, an understanding of bond pricing is required. Two things have the greatest effect on the pricing of bonds – interest rates and credit risk (A third factor is the accrued interest).

If the credit rating drops, the bond price might drop. This is straightforward.

If interest rates go up, bond prices will go down. And vice versa. To illustrate this concept, let’s look at a simplified example.

Suppose the risk free interest rate is 4% and you have a 2-year bond with a face value of $100 that pays a 4% coupon every year. In this case, your yield is 4%.

Assume the risk free interest rate increases to 6%. Nobody will want to buy your bond at $100 as he can get a better yield leaving his money in the bank. However, if a person can get a yield of close to 6% by buying from you at a reduced price, he might do so.

This price will be about $96. His returns over two years are $4 + $4 + $100 and his cost is $96. That works out (this is not the exact calculation) to be about 6.07% pa.

On the other hand, if the risk free interest rates drops to 2%, people will be more than willing to buy your bond for $100 to get the 4% coupon and yield.

In this case, the price will probably move closer to around $104. His returns over two years are $108 and his cost is $104. This works out to be about 1.9% pa.

For bonds, you can really get into trouble if interest rates spikes up. Imagine if the risk free rate is 20% pa. Your money will be stuck inside earning low yields with no possibility of liquidating it as the market value for the bond would be very low.

That more or less explains how the price of preference shares will be quoted on the secondary market. Very much like a bond price and not much to do with the price of the mother share (As there is no term to maturity, the calculation is slightly different from my earlier example). However, if the mother share collapses due to credit issues, the preference share price will be adversely affected.

This is also one additional thing. Because the preference shares can be redeemed at the option of OCBC after five years and on the occurence of certain events, it puts an artificial cap on the price it can attain. No one will want to pay too high a price for it since there is always a risk that it has to be sold back to OCBC at the face value.

That brings us to the last point. The redemption price.

If OCBC decides to redeem the preference shares (there are a few scenarios given in the prospectus that they can do so), they will have to pay the face value ($100) and any accrued dividends. The latter simply means the prorated amount of dividends owed to you. The market price it is trading at that time is irrelevant.

In the event of a liquidation and winding up of OCBC, bond holders get first priority, followed by owners of preference shares and then ordinary shareholders. If the liquidation assets are not sufficient to cover the obligations of the bonds and preference shares, you will get back less than the face value of your preference shares.

Comments

  1. San says

    Hi! Pls help me with this question: what happens to preference shares when a company is acquired by another? Will the other company redeem the shares at par?

    Thanks a lot!

  2. says

    Hi San,

    For OCBC preference shares, the prospectus has this to say on page B-6:

    ” “Permitted Reorganisation” means a solvent reconstruction, amalgamation, reorganisation, merger or consolidation whereby all or substantially all the business, undertaking and assets of OCBC Bank are transferred to a successor entity which assumes all the obligations of OCBC Bank under the Preference Shares.”

    Having defined this, unfortunately, there is no further mention when permitted reorganisation is applicable.

    Therefore, I can’t really answer your question with absolute certainty. I would think that for in a M & A, the acquirer can either undertake the obligations of the preference shares, or request OCBC to redeem them before going ahead with the acquisition.

    You might want to verify this with OCBC.

    If you are asking this question in general, the first place to check would be the prospectus. There isn’t any standard answer for this.

  3. Uttam Biswas says

    Hi! I have to do a project on the title “issue of preference capital”.I’m a first year student of mba in a reputed b-school.Please help me out by replying with some good articles asap.

  4. says

    Posting my answer to this question for the benefit of all:

    “Do you mind give me the detail formulas on your calculation on the yield 6.07%pa and 1.9%pa as shown below?

    “This price will be about $96. His returns over two years are $4 + $4 + $100 and his cost is $96. That works out (this is not the exact calculation) to be about 6.07% pa.”

    “In this case, the price will probably move closer to around $104. His returns over two years are $108 and his cost is $104. This works out to be about 1.9% pa.”

    Thanks so much for your guidance & advise.”

    In the first example, the total profit is $12 : $8 from the 2 dividend payouts and $4 from the capital gains ($100-96). Overall % returns about 12/96.

    In the second example, the total profit is $4 : $8 from the 2 dividend payouts and a loss of $4 on capital ($100-104). Overall % returns about 4/104.

    Annualize them both and you will get my figures.

  5. freeier says

    one point you might want to rephrase, preference share gets preference in dividend. i.e. if company wants to give any amount of dividend to normal share holder, they HAVE to give the pref share dividend. On years where they decide not to give normal share dividend, they can choose not to pay pref share holders. that’s why its called pref shares.

  6. banyan says

    The OCBC Bk 5.1% pref share has dropped almost 10% below par. Since the interest rate is unlikely go down any further and nobody will be interested to buy them from secondary market even when market picks up, the price will be traded lower. Is it advisable to cut loss now?

    • says

      banyan,

      Preference shares are meant to be long term holdings with a steady dividend.

      If you had that intention in mind when you purchased it, why should you let the current quoted market price affect you?

      Preference shares do not have a fixed maturity date and the secondary market serves to provide an alternative exit for those who need it. Do you? Has anything about the preference shares changed since you bought it?

  7. banyan says

    lioninvestor,

    Although I am a long term investor, I feel there is little upside for preference shares even when market is good. So I am afraid it is similar to minibond. Just one is disguised as fixed deposit with high interest rate while the other is disguised as bond with high yield. What scenario do you think the price can rise? Correct me if I am wrong.

    • says

      banyan,

      the preference shares is never meant for capital gains. It’s more of a dividend play with price trading close to par. Of course, interest rates might affect it’s valuation, just like a bond.

      If you want to gain exposure to the profits of the company, then normal shares are a better way.

  8. checker says

    only issue i see about preference share is that when a bank is not making money (especially this period), there maybe no dividend payout for common share holder and preference share holder.

    • Intheknow says

      Checker,

      Yout have pointed out the biggest danger of pref shares… whether the Bank will declare dividends on its ordinary shares.

      In this financial crisis, will DBS, UOB, OCBC continue to pay dividends to its ordinary share holders? If so, then all pref share holders will have to be fully dividends in full first.

      OCBC has mentioned it has not stopped its dividend payments since World World II. Let’s see if they will buck their trend soon.

      Nevertheless, even if the pref share only pays dividends once a year, the dividend yield of 2.55% if stilll higher than most fixed deposit rates now.

      Let’s wait and see as I am considering purchasing the pref shares in the market now. My personal opinion, at a price of about 90%, is a pretty decent deal.

  9. banyan says

    lioninvestor,

    The problem is the price keeps going south (I can’t see what can reverse the trend given current already low interest environment). Suppose the price drops to 50% and investors have to accumulate around 10 years’ dividend to recoup the principle. If OCBC lowers or stops dividend payment after 10 years, the time will get longer. So the best scenario is that OCBC redeems the pref shares, correct?

  10. Intheknow says

    1. Preference shares are not meant to be frequently traded. It’s meant for investors who don’t need their principal and just want a steady stream of dividends to flow in. Thus, the market price of pref shares should not be of any concern, if you are a long term investor.

    2. OCBC won’t redeem their pref shares if the market price is so low. By redeeming, they have to pay 100%. By buying from the open market, they only pay the market price.

    3. I am sure there will be a bottom for the pref shares. Just don’t know what’s the bottom. Let’s just observe and see. I have a feeling the prices are moving south because the local banks are expected to freeze their ordinary share dividend for some time (maybe 1-2 years). This would mean there are very likely NOT to pay pref share dividends as well. At a market price of 90%, the market is pricing in 2 years of ‘no pref share dividends’.

    • Jack says

      I also do not understand why the pref shares are only at 90%. The transacted volumes seems low so my guesses are:

      1. Seller needs money during this period.

      2. The unspoken fear that banks might fail – fear factor regardless of the facts or lack of. Continued depressed stock prices drives this fear deeper regardless of whether it has any bearing on the pref. shares.

      I rarely subscribed to IPO and this is one of those rare moments that I got ‘lucky’ as well. Otherwise, 90% is hard to resist.

  11. Kevin says

    OCBC Preference shares 5.1%NCPS 100:

    Dividend payout has just been given out.
    Payment Date: 22/12/08
    Cash Rate: 5.1%@150/365 (pro-rated say 150 days)
    Qty: 500*@S$100 (Say 500 shares)
    Gross Amt: $100*500*5.1%@150/365=$1,047.95
    Tax Deducted: TAX EXEMPT(1-TIER)
    Net Amount: $1,047.95
    CDP Handling Fee: $0.00
    GST: $0.00
    Amount Paid: SGD1,047.95

  12. Intheknow says

    pretty good!

    so why are OCBC 5.1%, DBS 6%, and UOB 5.05% pref shares trading below par?

    i never understood this, especially when interest rates are like crap now! investors should be GRABBING these high interest rate preference shares!

    UNLESS…. the local banks are expected to freeze dividend payment anytime soon!

  13. Philip says

    How do you buy preference shareson the secondary market? Can you do so via an online brokerage, and if sowhat is the code for the stock–and how do you obtain an up-to-date quotation of current price?

    P

  14. arman says

    10% preference shares fully paid to 2$, market price $1.80. what is the cost of the preference share?

  15. SWN says

    Hi Lioninvestor,

    What would happen to preference shareholders in the event of a merger or takeover of the Bank? Would the preferene shares be redeemed or taken over? Could the holders continue to hold the preference shares if the terms remain unchanged?

  16. johnraison says

    where on the web please can I find quotes for prices of Uk company preference shares?

  17. minu3t says

    HI Lioninvestor,

    can you help me with this matter?

    one company had issued redeemable preference share during the year, and at end of year they want to pay interest on the redeemable preference share holders on a certain percentage of interest rate.

    my question is, should the interest rate be stated on the Subscription Agreement?

    because i did not see any of such information about interest was mentioned in the Agreement. If they want to pay such interest, can they add it with the memorandum of agreement or another to superseded the previous agreement?

    thanks b4

    • says

      Hi minu3t,

      For preference shares, all the information is clearly spelt out in the prospectus or offering document.

      The formula they use for the interest could be based on a fixed rate or floating rate.

      If it’s based on a floating rate, then the actual interest rate would have to be determined closer to the point of payment.

  18. viiNn_ says

    Hi, can you help me??
    I have an assignment from my school..
    and the question is

    (1) 10% preference shares fully paid to $2, market price $1.80..

    how to solve it??what the formula to solve this question??
    thanks..
    Regards,
    viinN_

      • viiNn_ says

        they wanna asked me to calculated the cost of preference shares with that question…

      • Spandan Shrestha says

        hi lioninvesor,
        i got the same question for my assignment and the question is as follows:

        (a) What is the cost of the preference shares?
        (1) 10% preference shares fully paid to $2, market price $1.80.
        (2) 8% preference shares fully paid to $1, market price $1.20.
        (3) 12% preference shares fully paid to $5, market price $4.50.

        that is the whole question… i am not sure if the question itself is correct…don’t we need a certain amount of shares to go by to calculate preference shares?? If yes then can you show me an example. Thanks….i do appreciate it.

  19. Kim says

    Hi
    On the topic of preference shares, I have some DBS bank 6% NCD. The Divided stated in the propectus is 6% on or b4 15 May 2011. However, after this date, the dividend will be 3mths SOR + 2.28%.

    Pls advise if the dividend as per say ( I interprete base on above information) will be the current int rate + 2.28% and not the dividend declare on the ordinary shares + 2.28 % ?

    Very confuse, pls help ?

  20. Kim says

    Tks Martin.

    Btw, since PS are quite similar to bonds except that its maturity is perpertual, then what are the possible attractive reason to buy PS or to hold it than bonds ?

    To correct me if I am wrong :

    1) For bonds there is admin charges for holding whereas for PS there is none .

    2) “On the other hand, if a company pays out any dividends to its normal shareholders, then it has to fulfill its obligations to its preference shareholders first.”

    So apart from the interest given (SOR + 2.28%) , the holder could also received extra dividends if declared ???

    3) Any other reasons

    Is it wise to buy PS that is already at the end of the fixed dividend given ?

    I am looking at cash flow instead of capital gain pdt any lobang ?

    Tks for sharing >

    • says

      Hi Kim,

      For corporate bonds, if held in CDP, there’s no additional charges but if held on something like Euroclear, there would be a custodian fee (about 0.03%pa).

      The main restriction with corporate bonds (other than SGX listed bonds) for retail investors is the huge amount required (typically $250k min).

      For preference shares, the dividend stated is not guaranteed. However, if a dividend is paid to normal sharedholders, then the preference sharedholders have to be paid first. There is no extra dividends.

      As to whether buying the PS at the end of the fixed dividend period is wise, you have to compare it versus other alternatives in the markets.

      For stable cashflow, look at established companies in mature industries that pay out regular dividends.

  21. Fury says

    Hi lioninvestor,
    For UOB 5.05%NCPS 100, is the interest rate tied to the 3-month Singapore dollar swap offer rate like OCBCCap 5.1%NCPS 100 or it has a fixed payout like OCBCBK version?

  22. David Wong says

    Hi Lioninvestor,

    I’m trying to find out the interest payment date for DBS Bk 6% NCPS 10. Search through many website but still can’t find the dates. Can u help? Thks

  23. liewxun says

    Hi, how often do banks redeem the preference shares? Is it likely that I would be able to sell back the shares to the bank for the liquidation price in about 5 years time?

    • says

      Hi Liewxun,

      The nature of preference shares means that the company has the right but not the obligation to redeem them from you. If you need liquidity, your best bet is to sell them on the exchange. That can be done anytime at the market price.

  24. TravelKid says

    Hi LionInvestor,
    Since there is a very high chance that DBS will redeem their DBS Bk 6% NCPS in 2011, would they buy back the pref shares at the par value or they would expect us to sell them on the exchange ?

    • says

      Buy back at par. Sell on exchange only works if there is another buyer out there but no one will be willing to pay too much if they know that DBS can redeem at par any time.

  25. Debbie says

    Hi Lioninvestor,
    Thanks for the artical on PS and for the discussions above. I learnt a lot.

    I’m considering buying the DBS 4.7% Preferential shares currently on offer. I have a student loan in Malaysia at 4% interest rate p.a. I have sufficient cash (in savings account) to fully pay the student loan.

    However, I’m thinking of putting the money in the DBS Preferential Shares to earn a higher interest (4.7%), pay the student loan interest (4%) annually and pocket the difference.

    However, I’m not sure if this is a wise decision. Ultimately I would want to pay off my student loan, and if DBS does not choose to redeem it, I may have to sell it for less than par value in secondary market. Based on all discussions above, we should only buy Preferential Shares if we intend to hold them long term for purely dividend payout. Based on this, does it make sense for me to put the money in PS versus paying off my study loan in full, just to benefit from the interest difference (0.7%). I’m also aware that given my study loan is in Malaysia and the DBS PS is in Singapore, I’m also subjected to currency exchange risk.

    The other thing holding me back from buying this PS is I’m also thinking that since current interest rates are low and probably go up in future, the price of the PS on secondary market will more likely drop that rise (does not bode well for me when I’d like to sell my PS to pay off my student loan).

    Pls let me know your perspective on this. Thanks!

    Debbie.

  26. akuzike says

    There is a company with a long gestation period would you buy preference shares from this company?

  27. Lim Khan says

    Hi Lioninvestor,
    All these preference share notation 6%, 5.1%… indicate the yield return right?
    As you mentioned that they need not necessary pay the dividend. If they pay, do they need to pay the noted dividend as in DBS bk 6% must pay 6%? or can they choose not at a different yield?

    Thank you.

    DBS Bk 6% NCPS 10
    UOB 5.05%NCPS 100
    OCBC Bk 4.2%NCPS
    OCBC Bk 4.5%NCPS 100
    OCBC Bk 5.1%NCPS 100
    OCBCCap 5.1%NCPS 100

    • says

      Hi Lim Khan,

      the % indicate the coupon rate. The actual yield will depend on what price you buy the preference shares. If you bought them at face value, then the yield you get will be the same as the coupon rate.

      For preference shares, the entity can choose not to pay a dividend. However, if they choose to pay dividends to normal shareholders, then they must pay the stipulated dividends to the preference shareholders first before they can do so.

      There are cumulative and non-cumulative preference shares. For non-cumulative preference shares, if a company choose not to pay a dividend for that year, then you won’t get anything for that year and the company does not need to make up for it in future years.

      For cumulative preference shares, if the company skip a dividend, they will need to make up the shortfall in the future.

      • Lim Khan says

        thank you.
        I roughly got the ideas of preference from your previous post. Maybe I should rephrase my question again.
        For example DBS Bk 6% NCPS 10.
        As you mentioned the yield is the coupon rate of 6%, does it means it will pay 6% yield of dividends per annum if they choose to pay.

        Hence coupon rate of 6% is better than 5% if assumed other T & C are the same??

        Thanks again

        • says

          If the coupon rate is 5% and face value is $100, then they will pay $5 in dividends whenever declared.

          All things being equal, yes a 6% coupon will be better than 5%. But they are never equal.

          The preference shares you listed are all already trading on the market. So your yield will not only depend on that coupon rate, but also depend on the price you pay to buy it.

          If there are really two preference shares that are completely equal and issued by the same company but have different coupon rates (say 4% and 5%), then the one giving 5% will trade at a higher price than the one at 4%. The market will price them such that buying either will give you the same yield.

  28. ming says

    Hi lion investor,

    some questions

    If the coupon rate is 5% and I buy below par value, then the yield is 5% of the value I bought and not 5% of the par value. Am I rite?

    2nd question, if the yield is 5% and company declare divident, it will have to be 5%, not more not less rite?

    • says

      Ming,

      the dividend paid out is based on the par value. If the coupon rate is 5% and the par value is $100, the dividend will be $5 whether you bought the shares at $90, $100 or $110.

  29. pete says

    Hi Lioninvestor,
    I am looking at OCBC pref shares for long term reliable dividend income stream.

    Is there any particular reason that
    OCBC BK 5.1% NCPS 100 at 105.8 is trading at a much higher price than
    OCBC BK 4.5% NCPS 100 at 102.80 or
    OCBC BK 4.2% NCPS at 1.02?

    Thank you very much

    • says

      Hi Pete,

      There could be a few reasons.

      1) Different coupon rate. 5.1% vs 4.5% vs 4.2%
      2) Different date of dividend payout. The closer it is to payout date, the higher the price.
      3) Any redemption clause.
      4) Whether there is any change in coupon rate after X years.

      Generally, the market will be quite efficient in pricing in all these differences but the only way to check would be to go through the initial offering document of all the 3 different series. You can request for your broker to get them for you.

  30. yvonne says

    please help with the following question from my assignment:

    A company wants to buy preference shares worth USD$60 Million in a new company that is setting up a project that has a long gestation period. would you please advise as to whether the company should buy the shares or not?

  31. CH says

    Hi Lioninvestor

    can you share generally how the preference shares concept work in Singapore for private companies? i have an assgnment and am trying to explore the pros and cons for shareholders to provide shareholders’ loans or via preference shares, to a private company in Singapore.

    Can you help? Thanks.
    CH

  32. Abraham says

    How to calculate dividend yield ratio,p/e ratio (2005-2010)under Armour and columbia sports wears for preparing project report.
    Could any one help me to find it out at an earlier time

  33. Kc says

    How do you find cost of preference shares if you only have 15% preference shares, 12% dividend, US60 par value, 50% debenture, 35% ordinary shares, risk free=5%, return on the market is 12.5%, company tax=30% and Yield to Maturity=7.2% and beta=1.06

  34. EH says

    Hi lioninvestor,

    Considering that interest rates are low now, is it a good idea to buy into preference shares with 4.7%/5.1%? I am more worried that the banks will redeem these shares earlier and then I will lose the projected returns.

  35. WT says

    Hi Martin

    During the maturity date and the Company decides to redeem. Will the last payout be Capital + Dividend? Or just the Capital?

  36. samson bisafo says

    A company has 10,000 $1, ordinary shares and 4,000 6% cumulative preference shares of $1 each. The profits available for dividends are:

    Year 1 $350, Year 2 $500, Year 3 $200, Year 4 $400, year 5 $500. Draw up a table showing the dividends paid in each of th 5 years.

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