The case for preferred shares

Jollibee and Megawide will soon be launching preferred shares.

With the much higher yields of real estate trusts (REITs), why would some investors still want to buy preferred shares?

The main reason is that preferred shares are less risky compared to REITs, making them appropriate for more risk-averse investors.

While the amount of dividends paid by REITs can go up or down, depending on the income the company generates, dividends on preferred shares are fixed.

Although the rental income of all the newly listed REITs is projected to go up in the near term, there is a risk that profits and dividends will go down in the future, if the outlook of the office leasing market deteriorates.

In contrast, preferred shareholders can expect to receive the same amount of cash dividends as long as the issuing company is profitable. This is despite profits going up and down.

To raise cash, investors of both REITs and preferred shares can sell their holdings in the stock market. However, when market conditions are bad, REIT holders have no option but to sell their shares at a loss. In contrast, if the price of preferred shares is down, investors have the option to wait for the company to redeem their shares on the callable date to receive their principal in full.

Finally, in case a REIT company becomes bankrupt, REIT owners will be the last to be paid after the company sells its assets and pays its obligations.

Although preferred shareholders also have a lower priority of being paid compared to suppliers and creditors, they have a higher priority compared to common stockholders or REIT owners in the event of bankruptcy.

While preferred shares are less risky compared to REITs, they also carry some risk, which is why their yields are higher than bonds. Because of this, investors should also do their due diligence on the issuer and not just focus on the yield when buying preferred shares.

If a company issuing preferred shares loses money, it can choose not to pay cash dividends. Noncumulative preferred shares are even riskier, because a company has no obligation to pay any unpaid dividends in the future, even if the company finally turns around and becomes profitable.

Although a company will most likely redeem their shares on the callable date because of the step-up feature on the coupon, they are not obliged to do so. This is the reason why preferred shares are considered part of equity and not debt—when a company encounters financial difficulties, it can choose not to return the principal of preferred shareholders.

Investors who plan to buy preferred shares in the Philippine Stock Exchange (PSE) should also avoid using the issue’s dividend yield (which is computed as dividend/price) in comparing it to other fixed income instruments or dividend yielding stocks, especially when the preferred shares are trading at a premium to their par value. Note that when a company redeems its preferred shares on the callable date, it will only pay the par value of the preferred share and not the market price. Because of this, investors who are paying a premium can suffer from losses. The correct yield is preferred share’s yield to call.

Presently, the average dividend yield of preferred shares in the PSE is 6 percent. However, the average yield to call is much lower at 3.9 percent. Moreover, a number of preferred shares that are callable anytime starting this year have negative yield to calls. Because of this, buy preferred shares that are callable at least two years into the future. INQ