Investing In Preferred Shares/Stock And Corporate Debt

In this article I discuss items to consider when purchasing preferred shares/stock or other similar debt instruments of a company. This is a followup to the questions from  investors who were considering purchasing preferred shares/stock of Wells Fargo (WFC) and US Bancorp (USB).

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What Are Preferred Shares?

In general, preferred shares are a form of corporate debt that has some qualities of common shares as well as that of bonds. The main characteristic of preferred shares are that they pay a fixed return to the holder at regular specified intervals, usually in the form of a dividend. The dividend payment typically does not fluctuate or change over time as it is determined at the time of issue, unlike common shares. However, there are rate resetting preferred shares as well (where the payment is calculated based on a predetermined formula).  The preferred share represents partial ownership in the company just like common shares do. Often, they are redeemable by the corporation after a specified date.

When talking about preferred shares in general, I find it relevant to discuss other similar or related forms of preferred securities and corporate debt instruments. Other forms include subordinated debt/debentures/notes, senior/junior debentures, interest paying notes, preferred capital trust units, preferred notes, etc. Subordinated debt may also be in a form that is combined with preferred stock to create monthly income preferred stock. Such a hybrid combined form pay dividends to the investor (lender) but is placed as interest expense on the issuing company’s balance sheet.

To the average investor, all these debt instruments such as debentures or notes may seem the same as preferred shares, but they are not. They have their own conditions & stipulations, that need to be read in detail and understood (not difficult in any way, but still needs to be done). How the company puts these instruments on the balance sheet, or how they intend to fund the payments, may also be of relevant concern to each investor in assessing the company’s financial condition, and ability to make the payments. That being said, they often share the same type of features, as mentioned in the sections below. The remainder of the article will mention “preferred shares”, but the information will pertain to these similar corporate debt instruments.

Corporate bonds on the other hand are bonds issued by a corporation with a maturity date falling at least a year after their issue date. They essentially work no differently than bonds issued by government agencies, except that they are issued by the private sector. Commercial paper are corporate debt instruments that typically have shorter maturity than the bonds. Convertible bonds are corporate bonds that allow the holder to convert the bond into equity (common shares) at a predetermined exchange ratio.  I won’t be discussing these in this article.

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Naming Conventions

Preferred shares are also known as preferred stock, capital stock, and preference shares. Generally the name given also includes some of the qualities or characteristics defining the specific share issue. This includes many of the options and features such as cumulative/non-cumulative, yield at issue, series number/letter, redemption date, convertibility, etc.

Example:

– Vale Capital Ltd GTD NT SER RIO NT 5.50% (Vale Capital Ltd. 5.50% Guaranteed Notes Due 2010 “Series RIO Notes”) (Vale Capital is related to CVRD).
– Wells Fargo Capital XII 7.874% PFD (Wells Fargo & Co Enhanced TRUPS 7.875% junior subordinated deferable interest debentures).
– TD Capital Trust SER 2009CATS (TD Captial Trust Capital Trust Securities (CaTS) Series 2009).
– Nexen Inc PFD U NTS $US (Nexen 7.35% Subordinated Notes due 2043).
– Enbridge Inc 5.5% PFD A (Enbridge 5.50% Cumulative Redeemable Preference Shares, Series A).
– USB Capital XII GTD TR 6.30%PFD K (USB Capital XII 6.30% Trust Preferred Securities).
– The Bank of NS NON CUM PFD SERIES 12 (The Bank of Nova Scotia Non-Cumulative Preferred Shares Series 12).

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Why Are Preferred Shares Issued?

Its good to have an understanding of why preferred shares/stock are issued in the first place. In general, a company issues corporate debt instruments to raise capital for expansion, facilitate capital intensive operations, or maintain liquidity (as we’ve recently seen with the big banks). If a company wants capital but doesn’t want to increase the debt liabilities on their balance sheet, they could issue preferred shares instead of taking loans, issuing bonds, or the other corporate debt instruments. Going to the market for capital usually allows the company to get better terms or raise capital easier, which can be potentially cheaper as well. They would do this as long as they believe they would have the cash flow to pay the dividends that they stipulate for that issue. Benjamin Graham reminds us that investors should consider preferred share dividends as debt liabilities, even though it does not appear directly as one on the balance sheet, or in the debt ratios. That makes sense, because the dividend payment is still a monetary obligation and hence acts as a liability. These dividends are also not tax deductible to the company, making them a potentially expensive form of capital instead of a cheap one if the company does not do it properly. A preferred share issue is a tool that the company can use, but as with any debt related tools, it must be used carefully (if at all) with much consideration, and assessment of their financial & operating situation.

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Options & Features

– The major differentiating features of preferred shares are cumulative/non-cumulative, participating, and convertible. However, there are many more options & features that an investor needs to be aware of and look at when assessing such corporate debt instruments, many of which can be in different combination:

Cumulative / Non-Cumulative – If a company halts the dividend for a period of time, cumulative holders will be paid all their accumulated arrears before common shareholders get any dividends, once they are resumed. At redemption of the preferred shares by the corporation, holders are paid all their accumulated arrears. The corporation will usually have certain deferral options such as 20 consecutive quarters, or 5 years without being subject to obligations. Most US financial institutions issue cumulative, while most Canadian financial institutions are non-cumulative. Preferred shares must be non-cumulative if it is to be included in Tier 1 capital for financial institutions. The majority of preferred shares and subordinated notes are cumulative.  So what advantage is there of non-cumulative preferred shares to the investor, other than it being part of Tier 1 capital?  Probably nothing on its own.  The issue would likely have other features/options that would make a non-cumulative preferred share more attractive.

Payment Rate/Yield – The payment can be in the form of interest, dividends, and can be currency specific. Payments, no matter how they are calculated for each specific payment date, are declared at the time of original issue. Most dividend payments are at a fixed rate on the par value at time of issue, and will never change even if the company becomes more profitable. Some dividends are an adjustable-rate (floating-rate) type, that changes each quarter. Others have rates that reset every five years. Adjustable & resetting rate types are usually based on a specific predetermined formula that may include the LIBOR, yield on Treasury bills, or other central bank rate. The yield on most preferred shares from US financial institutions is not adjustable, while a good portion preferred shares from Canadian financial institutions have yield rates that reset every 5 years.

Participating – Holders of preferred securities are eligible to receive additional dividends from the company earnings, above the stated amount under specific conditions.

Perpetual – There is no fixed date on which the invested capital is to be returned to the holder. However it is common that the company will hold certain redemption privileges. A drawback may be that having no maturity date, given certain market conditions, the current market price may remain at low levels for long periods of time.  That means the investor needs to factor in the possibility that they might have to hold onto the securities longer, or sustain a bit of loss on the security’s market price.

Maturity – If a maturity date is specified, it is usually at least 5 years from the date of issue.  At maturity the principal is to be repaid and the securities are redeemed by the corporation. The corporation may hold the option of repaying the principal in cash or in common shares at a predetermined ratio.

Convertibility – Some preferred securities & notes give the holder the option to convert/exchange the securities into the company’s common shares (or affiliated company’s shares), while others do not. Some even have mandatory conversion features. This might be at a predetermined ratio, specified price, or may be at any time the holder chooses (regardless of market price of common stock). The exchange or conversion may also be only after a predetermined date. Usually an exchange, is non-reversible once it has been converted.

Redemption – Redemption by the corporation generally occurs at maturity, but may also occur earlier at a specified “earliest redemption” date, or at its discretion (when the company wants to retire some debt early). With corporate debt instruments the redemption or “call” privileges held by the corporation may or may not specify the amount (min and/or max) of the securities that can be repurchased early. Generally the corporation repays 100% of the principal, but this too can be specified to be a different percentage. There may also be some defined conversion features/options at redemption for the company or holder as previously mentioned. There may also be some redemption privileges held by the holders. Some feature a “put” option, where the holder would upon certain conditions, force the corporate to redeem the securities. “Putable preferred shares” feature this option. A drawback of preferred securities is that because many issues have redemption conditions either at maturity or at another specified time, the market price usually does not increase over their par value, and may even remain slightly below it.

Holder Rights – The main holder right is preference in the payment of dividends/interest. Before a dividend can be declared on common shares, the payment obligations to the corporate debt instrument holders need to be met. There is usually a claim on liquidation proceeds of the corporation, which would rank behind other more senior debts when the corporation falls into receivership. Bondholders have priority over holders of preferred shares. This is true for both payments and proceeds in the case of bankruptcy. Generally, preferred share series issued later, rank behind earlier ones (seniority basis). Typically these securities  do not have voting rights. However, voting rights may be granted when payment is in arrears. Usually there are also provisions prohibiting the company from creating any other class of shares ranking prior to or on parity with the specified preferred shares, increasing the authorized number of shares, or amending the provisions originally attached to the shares, without approval of the current holders. There may also be special voting rights that are associated with the securities for specific circumstances, such as merger & acquisition approval, or election of directors.

Warrants – A warrant to purchase up to a specified number of common shares of the company, at a specified exercise price per share. The warrants would be subject to certain anti-dilution and other adjustments. The warrants may be exercised for up to a specified number of years after being issued. Warrants may also be declared or granted to holders, without being specified at the original date of issue.

Dates – There is generally a specified date for dividend/interest payments, maturity, redemption. There may or may not be a specified date with the other mentioned features/options above.

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Can Dividends Payments On Preferred Shares Be Halted or Reduced/Cut?

Usually the corporation stipulates conditions where it does not have to pay dividends/interest on preferred shares and similar corporate debt instruments if it lacks the financial ability to do so. This is unlike interest on bonds, which must be paid to avoid default. This is where the cumulative option (as described in the above section) comes into play. However, since the payment is fixed, it cannot be reduced. It is possible that at the time of issue, the corporation may have stated it would have the choice to invoke convertibility options in special financial circumstances, in order to avoid skipping payments and satisfy holders.

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What Is Likelihood of Skipped Dividend Payments?

If capital and cash flow becomes such a large problem that they cannot service their debt obligations, they may need to halt or skip the preferred stock dividend, and payment on other similar debt instruments. However, doing so raises serious issues about the financial stability of the company. The consequence would also be that they would not be able to successfully raise any new capital by selling/issuing new corporate debt instruments again. This is because no one would trust that they would be able to sustain any payments on the new issues/series, due to skipped payments on previous and more senior issues. A payment stoppage would only be done as a last resort. As I’ve mentioned in one of the previous articles concerning the Wells Fargo & Co preferred shares Q&A, the likelihood of a halt is therefore related to scenarios that would lead to dire financial circumstances occurring. This is where the investor must dig into the financial statements, as well as the business operations to assess the risks affecting the company’s financials.  The investor would need to determine the probability of those risks occurring that may severely restrict income and cash flow to a point where the obligation to corporate debt holders cannot be met. Many investors may have been attracted by the yield, which may have blinded them from the risks that their assessment may have indicated.

Example:

– Citigroup, has continued to pay dividends on their preferred shares in spite of what has happened. Their last payment was February 27, 2009, on their Series T, AA, and F. However, if they had not been bailed out on numerous occasions, they may have become insolvent and unable to service their preferred share obligations.
– GM is another example, but they are in the worst case scenario where they cannot even pay their obligations to their corporate bond holders. They are now planning to make an exchange offer to the bond holders, offering to exchange the bonds for equity (common shares).

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Are Preferred Shares A Good Investment?

In general, these can be a good investment depending on the investor’s situation, and the specific issue. It really depends on what you want to get out of it, so you need to ask yourself a few questions:

– Are you looking for a investment that gives continued dividend/interest payments with some degree of certainty?
– How and when does such an investment fit into your overall plan, if at all?
– What type of features do you need for your investment plan?
– Do you understand how these work?
– What type of companies do you understand and can perform analysis on?

These questions will help determine which corporations to look at, and perhaps the type of features you are looking for in a specific issue that may make them more suitable over other types of investments for fulfilling a particular purpose. For example, purchasing George Weston 5.15% Cumulative Series II preferred shares if you don’t care about fixed payments, or are looking for price appreciation, or don’t understand the challenges their industry faces, or don’t understand the operations of the business itself, may not be such a good idea.

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Overall Considerations When Investing In Preferred Shares & Corporate Debt Instruments

The world of preferred shares and corporate debt instruments is highly customized. And due to such a high degree of customization from each corporation, investors need to treat each corporate debt instrument as a entirely distinct investment. Fully understand and be aware of all the features & stipulated conditions. All conditions, provisions, numbers, dates, options, rights, & other features are spelled out in their corresponding prospectus. It is basically like a loan contract between the corporation and the holder of the security. Like any other legal arrangement, they can specify almost any type of right or condition conceivable.

Remember, preferred shares and similar corporate debt instruments are just another category of tools that investors have at their disposal. The tools have certain limitations, advantages/disadvantages, and a wide variety of features. The exact conditions of each may make one issue more suitable than another, depending on what role or purpose these tools are intended to fulfill in the overall wealth building & investment plan of each individual investor. As an investor you need to assess whether it is a good fit, at a particular point in time. What might not be suitable now, may become suitable when you reach a specific part in the plan. However, even when it is a suitable investment, the current market price may not be favorable enough, and vice-versa.

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This article just touches on the corporate debt instruments, and is a starting point.  There are many more details & conditions attached to each option/feature. But  hopefully this article points you in the correct direction, and what other information to look for.

For the Q&A article related the Wells Fargo & USB preferred shares click here.

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Thanks & Happy Investing!
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