 |
Preferred Shares: The Pros and Cons of the “In Vogue” Financial Product
 | By Juan Palacios, Professor at IESE Over the last year, we have observed numerous issues of preferred shares by various banks and savings banks. The banking system needs capital and this mechanism seems to be a good way of obtaining it. Through these issues, banks found a cheap and stable way of boosting their equity capital. |
Although there are other methods to obtain funding, such as increases in share capital—with the appropriate placement of their ordinary shares with institutional investors—the issue of preferred shares provides the institutions with a more stable allocation. The small investor has a longer timeframe when buying securities, compared with the institutional investor who, depending on the performance of the markets, is always prepared to sell, with the consequent reduction in stability. In addition, this method allows the banks to have a very firm control over the sales of these assets through their distribution networks, which works out far cheaper for them. Undertaking a major issue entails paying fees to an investment bank, underwriting the issue, etc. Preferred shares are an economical way for them to obtain non-debt securities. The advantages for the banking institutions in issuing this product are evident, but what about small investors? Are preferred shares an attractive choice for them? Each issue was subject to a fresh warning published by the CNMV. The debate surrounding these issues makes it necessary to provide the small investor with clear, concise information. The CNMV prepared a leaflet on the subject explaining the characteristics of these assets and defining preferred shares as “securities issued by a company that confer neither a stake in its capital nor voting rights. They are perpetual and do not have a guaranteed return.” We will use this space to decipher which important aspects are to be found behind this definition and which are the key factors that small investors must bear in mind before spending a portion of their savings on this product.
 |
|
|
|
|
|
|
|
|
|
It Is Not a "Vanilla" Product
Preferred shares are not a simple product; they are instead a complex instrument, a hybrid instrument halfway between a common stock and a bond. They are like bonds in that, for an initial period, they have a specified payment, but this payment is not an interest but a dividend on profits, as in the case of a common stock, which means that the risk assumed by the investor is considerably greater than that of a bond holder. They are called “preferred shares” because in the order of priority—in the event that the entity has to pay a return—they come immediately behind all creditors, but ahead of common stocks, which will not receive any dividend until the preferred shares have been paid.
Their Return Is Open to Debate
The payment made on preferred shares is preset for an initial period, after which the banks and savings banks tend to link this return to the evolution of the Euribor. Three basic points related to the dividend payment must be made clear: 1) It should be remembered that the dividend payment made on preferred shares depends on the availability of distributable earnings. That is, if the issuer fails to make profits, the investor will not receive the dividend payment agreed for that period and will lose the right to receive it, since it is not cumulative. 2) This point refers to the preset dividends for the initial period. The returns on which preferred shares are being placed are low, and have been around half or barely above half of the return of ordinary shares of the same entities dividends. In addition, the CNMV has warned that certain issues are not being made under market conditions. 3) As soon as the yield is pegged to movements in the Euribor, it becomes subject to both upward and downward fluctuations, making it possible for both positive and negative returns to be generated on the capital invested.
Perpetual Investment
The lack of liquidity is one of the basic problems with this type of investment. Common stocks are extremely liquid assets, they may be bought and sold without any problems, and a deposit has a specified maturity, but here we are looking at a product that is perpetual and where it is extremely difficult to sell, which ends up meaning losses for those investors who decide to sell in advance. In these cases the investor must go to an unlisted market where it is not always easy to find a buyer for the preferred shares. The lack of buyers and the current market conditions may cause the price fixed for the product to be lower than the value paid by the investor at the time of the acquisition. If this occurs, the investor would lose part of his or her initial investment. In addition, some entities are now repurchasing these securities from their small investors at half of their original value, which represents a loss of 50% for these clients. Nevertheless, we should point out that, as the CNMV states: “despite being perpetual securities, the issuer usually reserves the right to redeem them after five years, subject to authorization from the Bank of Spain.”
High Risk
The CNMV classifies preferred shares as “a complex and high-risk instrument.” Indeed, this type of investment does entail a higher risk than that of a deposit, being in this regard more similar to ordinary shares. Preferred shares are not covered by the Spanish Guarantee Fund for Deposits and, even though they may be “preferred,” we have already made it clear that they do not enjoy the privileged terms of bonds. In the event of the liquidation or insolvency of the company, they come behind creditors and immediately ahead of shareholders. In addition, under such circumstances the company may liquidate the issue for a value below par, giving rise to losses for the holders of these securities. This being the case, it is clear that preferred shares are not a suitable product for conservative, risk-averse investors who seek a secure return.
For such investors, the best advice is to invest in simple products that they can easily understand with fixed interest rates and low risk. Treasury Bills might be a good alternative and may be acquired either through their bank or via Internet, from the Public Treasury, at market prices and free of commission.
Other products may also be of interest, such as money market deposits and funds, though in these cases it must be kept in mind that the value of the commissions should not entirely consume the return. Should you prefer to assume higher risks in your investments, ordinary shares are a good alternative. The top shares on the Spanish Stock Exchange are generally securities of excellent quality companies, including banks, and are paying very high dividends. Right now is a very good time to buy ordinary shares and invest in the stock market if you are a long-term investor. In short, every investor, depending on their profile, must adjust their investments for a higher or lower level of risk, but should they decide to embark on guaranteed, structured or similar products, my advice is to obtain plenty of information and bear in mind that sometimes these products can be confusing even for experts. |
|
|
|
