Discovering Preference Shares

I don't yet hold any preference shares in the DIY Income Investor porfolio but the high yields on offer mean that this is a type of security that might be worth considering.
Preference shares (or 'prefs') are a bit obscure but are quoted on the LSE (and on other exchanges as well) and are within reach of ordinary investors. Let's find out more...

Preference shares are so called because they have 'preference' over ordinary shares for payment of dividend or return of capital. However, they are junior to all forms of company debt, including debentures, loan notes and bank debt if the company is wound up.

Preference shares can be thought of as a hybrid between  an ordinary share and a corporate bond:

• Preference shareholders receive a fixed dividend, similar to the interest ('coupon') paid on a bond)
• Unlike bond interest, though, the failure to pay a preference dividend cannot force the company into administration - however, most preference shares are 'cumulative'; this means that any preference dividends not paid will be accrued until funds are available, and must be paid out in full before ordinary shareholders receive anything
• If the business is wound up, and there is any capital left over after paying the various creditors, preference shares are repaid before ordinary shares
• Preference dividends must be paid out before any dividends to ordinary shareholders
• Dividends on preference shares are paid out of taxed company profits and thus treated as 'franked investment income'

For the investor, 'prefs' can be seen as less risky than ordinary shares but riskier than bonds. Conversely, for the company, paying preference dividends is more onerous than paying ordinary dividends, but without the imperative of paying interest.

Some preference shares are traded on the LSE - mostly issued by financial institutions, for example (as of early July 2011):

• General Accident 8 7/8% Cum (LSE: GACA) paying 7.7%
• Bristol & West 8 1/8% Non-Cum,  (LSE:BWSA) paying 11.3%
• Santander UK 10 3/8% Gross Non-Cum (LSE:SAN) paying 8.72%

The yields (which are net, after basic rate tax) reflect the perceived riskiness of the investments - and you would need to form your own opinion on the health and prospects of those companies before buying.

There is a useful list of preference shares on the website of Collins Stewart, updated weekly (it also includes PIBS, which we have discussed previously).

Prefs pay dividends twice annually and these are paid 'net', meaning that the basic rate UK Income Tax has already been deducted, as for dividend income. There is, therefore, no great disadvantage for basic-rate taxpayers if they are held outside an ISA. However, the income from commercial bonds is paid gross - so would be better held inside an ISA.

Most prefs are undated, but one or two have a final redemption date. As noted above, most are also 'cumulative': this means the company is obliged to pay any pref arrears from previous years before it can pay an ordinary dividend. The non-cumulative pref shares are generally those issued by banks to boost their 'tier 1' capital bases.

The price quoted for prefs is the "dirty price" i.e. with accrued dividend included in the dealing price - for bonds the accrued 'coupon' is separate.

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.