In Part 1, we introduced a new class of shares you might not have heard of – preference shares.
In part 2, we’ll look at what might put your money at risk before you invest in preference shares.
Unlike common shares where you will typically find lots of buyers and sellers, the market for preference shares is much smaller.
This means that when the time comes for you to sell your shares, you might be faced with the problem of a lack of buyer, or you might need to sell at a lower price than what you had wished for.
The selling price of your shares will also affect the effective yield of your investment.
Interest Rate Risk
Things that can affect the price movement of a preferred stock include interest rates. Like bonds, prices of preference shares have an inverse relationship with interest rates.
If interest rates fall, the price of a preference share should go up. The idea is that investors are better off buying a preference share since the returns are better than other lower-interest yielding instruments available in the market.
A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments.
While preference shares typically acquire a higher credit risk rating, such as “A” by Fitch and “A3” by Moody’s, a downgrade of the issuer’s credit risk rating can affect the price of its shares if it is deemed more “risky”.
Most preferred shares are issued with provisions allowing the company, at its discretion, to ‘call’ (buy back) the shares at a predetermined price(usually the par value).
This is usually bad news for investors, as a preferred share is usually bought for the sake of earning dividend yields so getting your money back earlier will affect your overall returns.
FYI, this has already happened with a previous DBS preference stock.
Bond Or Preference Share?
Because of its bond-like nature, some investors consider preference shares a better buy compared to bonds because it typically promises a better yield. However, there are a few keypoints you should take note here:
1) Bonds are considered a fixed income instrument not just because it pays out a regular interest payment, but also because it has a redemption date which guarantees the return of your principal.
Since preference shares do not have a maturity date, there is a risk of having your money stuck there, or you’d have to sell it off on the stocks market (possibly at a loss).
2) The risk of early redemption by the issuer is a very plausible scenario. Companies will not usually issue a call back when the preferred shares are trading below par value.
The lower price and high dividend yield, prove they would have to issue replacements at a higher dividend rate than the current security.
On the flipside, companies are likely to call shares when they are trading above par.
From the issuer’s point of view, when the shares are trading above par (they buy back at par), it means they can refinance at lower rates so why would they not do that?
So as an investor, you need to think twice about a purchase above par value because you need to subtract the annualized capital loss that will result from the company calling the issue at the earliest date possible.
So… are bonds or preference shares better?
If you want something fuss-free, bonds might be your choice as you can literally buy it, close one eye and wait for maturity to get your guaranteed returns.
If you want to risk a little to get a higher dividend, calculate the returns you can make from your preference shares in case of early redemption to ensure you get the returns you expect.
Share this useful article on preference shares with your friends, or read part I in case you missed it!