Why you should be investing in preferred shares

Numerous companies are currently issuing preferred shares. This June, Petron and Arthaland issued preferred shares, while Vista Land is also taking steps to prepare for its own issuance.

Compared to bonds, preferred shares seem to be more attractive for the following reasons:
Preferred shares provide higher yields compared to bonds. For example, the yields of Petron and Arthaland preferred shares are between 6.9 percent and 7.1 percent while the yields of the upcoming bond issuances of several banks such as Chinabank, Security Bank, Metrobank, Union Bank and RCBC are between 5.5 percent and 6.15 percent.

The higher yield of preferred shares is partly because they have longer tenors or perpetual or forever while bonds have a fixed tenor of a certain number of years (mostly two years for the issuances mentioned above).

Dividends of preferred shares are taxed at a lower 10 percent compared to the 20 percent for bonds.

This further increases the net yield of preferred shares at 6.2 percent to 6.4 percent compared to bonds at 4.4 percent to 5.7 percent.

Finally, preferred shares can be sold through the Philippine Stock Exchange while bonds can only be sold over the counter.

These, in my opinion, make selling preferred shares more convenient compared to bonds for investors who may want to lock in gains in the future.

However, there is no such thing as free lunch. Preferred shares are also riskier compared to bonds, justifying their higher yields.

Although preferred shares are more expensive, companies that issue preferred shares are willing to pay the higher price because they have higher debt levels compared to companies issuing bonds. Most of the time, these companies are at risk of breaking certain debt covenants making it difficult for them to issue bonds or borrow from banks, thus prompting them to issue preferred shares instead.

Moreover, although companies that encounter financial difficulties are still obligated to pay coupons on bonds, companies that issue preferred shares are not obligated to pay dividends. The only consolation for owners of preferred shares is that a distressed company will still need to pay all unpaid dividends to preferred shareholders once it turns around. Otherwise, it cannot pay cash dividends to its common shareholders.

Nevertheless, while preferred shares are riskier compared to bonds, it doesn’t mean that an intelligent investor should avoid them. To protect yourself from potential losses, you can do some due diligence. For example, you can study the issuing company’s business and try to assess their outlook.

Moreover, try to determine if the issuing company has a good source of recurring cash flow that will allow it to continue paying dividends into the future. Assuming the issuing company has a favorable earnings outlook and a good source of recurring cash, there’s no reason why you shouldn’t buy their preferred shares.