Jun 05 2008
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.
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!
[Reply]
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.
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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.
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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.
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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.
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lioninvestor Reply:
October 20th, 2008 at 11:19 am
Ok. Added it in.
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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?
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lioninvestor Reply:
October 24th, 2008 at 1:57 am
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?
[Reply]
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.
[Reply]
lioninvestor Reply:
October 25th, 2008 at 8:36 pm
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.
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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.
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Intheknow Reply:
October 25th, 2008 at 8:37 pm
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.
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lioninvestor Reply:
October 25th, 2008 at 8:37 pm
You are right. The bank has the choice not to give out any dividends to anyone. This might happen if they really need the cash.
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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?
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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’.
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