Preference shares Part II

I've written this article on preference shares a long time ago, suitably titled as Preference Shares Part I. I thought I should finish that article now, haha, after so long!



To have a quick recap, let's go through some of the terms. Nothing much had changed since the last definition, but today I'm not in the mood for fancy words, so let's just use plain Jane terms. There are a few terms in preference shares that need to be understood.



Non-cumulative : This means that if they did not give out a payment in the stated date, they will not accumulate that payment to pay more in the next payment date. In other words, the payment is not guaranteed, unlike a bond. However, all of the preference shares I saw state that if the ordinary shares are given a payment, they are also obliged to pay for the preference shares. Cumulative means that if the payment is somehow not given for this particular payment date, it will be accrued and paid on the next payment date. Non-cumulative is important because I just read from my older post that only non-cumulative ones are placed in Tier 1 capital for banks. Not sure if that's still in effect now, given the new basel III regulatory rules.



Non-convertible : This means that the preference shares cannot be converted into ordinary shares. Convertible of course means that it can be changed to ordinary shares.



Par value: Each preference share is issued at par value. Let's say the par value of this particular one is 100 upon issue. The preference share is traded in the open market, so it will be subjected to price volatility, meaning that it can go above or below the par value. During the crisis, most if not all the preference shares are traded way below the par value, but I think now most are trading above it. It's important to understand that if the issuer is to call back the preference shares, they will buy from you back at the par value. Hence, it's a good idea to buy yours at below par, so as secure a capital gains on top of any dividend payment. Unlike a bond where there is a maturity date (where the issuer will buy back the bond at par value), there isn't one for preference shares. There will, however, be a callable date, after which it may be liable for call back at par value.



This is not to say that buying above par value is a bad thing. If the preference shares pay you 5% pa and you buy above par value by 2%, it's still a good deal if it is called back after 1 yr because you'll still get 3% (5-2=3) returns. Of course, if you buy below par value, then there will be a margin of safety, so to speak. Price volatility is not a problem as long as you hold it till the issuer calls back the shares. In the worst case, if the issuer goes belly up, then too bad, you get almost nothing.



In the event of liquidation, where the assets of the company that issued the preference shares are to be sold, the creditors will get the first tranche of money. Creditors will be those that buy bonds. However, preference shares are ranked above ordinary shares.  Hence preference shares are junior to bonds but senior to ordinary shares in the event of liquidation. Let's hope nothing of that sort happens in the first place, so place your bets on companies that are safe. No point getting a preference shares of 15% pa on a very risky company. I believe when one is buying preference shares, you want to have the liquidity of share market to buy in or sell out yet at the same time have a sort of nonchalance to price movement. Getting preference shares is the surest thing to getting a almost guaranteed dividend income without worrying about price movement.



I had bought this non-cumulative, non-convertible 6.20% preference shares from hsbc, with par value of 25 USD. Callable date 16th Dec 2010 and anytime after that date. Dividend comes in quarterly tranches per year, on the 15th of March, June, Sept and Dec. I'll work out some calculations here for my own reference in the future.


Price bought: 24.1 USD
Yield : 6.2/24.1 x 25 : 6.43% pa
Price discount to par value : 1-24.1/25 = 3.6%


If they recall back on 16th Dec 2010, I'll get at least one quarter of the yearly dividends, or 1.61% (6.43/4). Since they will have to buy back from me at par, I'll get 5.2% (3.6+1.61) returns before commission and forex. If they recall one year later, I'll be looking at 3.6% + n (6.43)% returns, where n is the number of full years I'm holding. Sounds like a good deal to me.