Why Are Preference Shares Considered a Hybrid Source of Finance?
Preference shares are a unique financial instrument that combines characteristics of both equity and debt. In this article, we will delve into why preference shares are considered hybrid, and explore the advantages and disadvantages of using them as a source of finance for companies.
The Nature of Preference Shares
Preference shares are equity shares that embody a mix of features from both debt and equity securities. Unlike common shares, which grant voting rights, preference shares typically do not confer such rights. However, they do offer a preference in terms of dividend payments and asset distribution during a company’s liquidation. [1] Specifically, the dividends of preference shares are paid before those for common shares, and the preference shareholders would be the first in line to claim company assets in the event of liquidation. Such preference in income and asset distribution is a key characteristic that sets preference shares apart, contributing to their hybrid nature.
The Fixed Income Aspect
Like bonds, preference shares often come with a fixed dividend rate. This fixed dividend rate typically offers a higher yield compared to the variable dividends of common shares. Preference shares may also have the cumulative feature, wherein if a company is unable to pay dividends in one year, those unpaid dividends are carried forward to the next year. This ensures that shareholders have a level of security and confidence in their returns, much like bond holders ([2]). These fixed features underscore the debt-like aspect of preference shares, making them a hybrid security with a fixed income component.
The Equity Component and Limitations
While preference shares have these fixed dividend characteristics, their return potential is limited. The cap on upside potential means that any amount above the fixed dividend rate cannot be retained and distributed to preference shareholders. Instead, this exceeds goes to common shareholders, reflecting their equity nature but with limited upside. This feature makes preference shares more aligned with equity than with debt, contributing to their hybrid classification.
Stability and Risk
The price stability of preference shares is often more consistent than that of common stocks, but they remain less stable than investment-grade bonds. This midpoint between equity and debt in terms of risk and stability is a hallmark of hybrid securities. Thus, the preferences shares’ fluctuation in market value can provide investors with a degree of predictability, similar to fixed income investments, yet with the potential for higher returns than typical bonds ([3]).
Marketability and Usage
While preference shares offer a unique blend of debt-like and equity-like features, they form only a small portion of a company’s total equity issues (usually less than 10%). There are several reasons for this. Firstly, the complexity of preference shares can confuse some investors, leading to lower demand. Secondly, common stocks and bonds typically provide sufficient financing options, reducing the need for preference shares. This rarity further contributes to their hybrid status, as these securities are less commonly traded and understood in the market.
Conclusion
In summary, preference shares are a unique hybrid security that combines the elements of both debt and equity. Their fixed dividend payments, paired with capped upside potential, give them a fixed income aspect reminiscent of bonds, while their preference in income and asset distribution make them resemble common shares in certain respects. This dual nature makes preference shares a hybrid source of finance, suitable for companies seeking a blend of fixed income and equity financing options.
References:
[1] Investopedia. (2023). Preference Shares. Retrieved from [2] Bogle, J. (2020). Common Stocks and hybrid Securities. Retrieved from [3] American Stock Exchange. (2023). What are preference Shares? Retrieved from