What are preference shares?
Preference shares are equity instruments issued by companies to investors to raise funds. While they have some similarities with the more common ‘ordinary shares’, their differentiators are an explicit fixed or capped rate of return in the form of a preference dividend which is payable to preference shareholders.
Also, in the event of a liquidation of the company, preference shareholders rank higher than ordinary shareholders in terms of who receives payment first. Although in practice, any equity holders are unlikely to see much by way of proceeds as almost all other creditors still rank higher.
Which are the best UK stockbrokers for preference shares?
We’ve shortlisted the best of the best UK stockbrokers below to help you start a preference share portfolio:
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What is the purpose of preference shares?
Preference shares are a method to raise corporate finance at a lower cost of capital than ordinary shares, but while passing on more risk to the investor than other forms of finance such as debentures, bank loans and corporate bonds. Preference shareholders, unlike lenders, usually have no right to call for the windup of a company to recover a defaulted preference dividend.
In fact, the terms and conditions of many preference dividends state that if the company has insufficient profits to pay the dividend then it will be waived for that period. In some cases, the dividend will not be waived but treated as merely ‘deferred’ until profits are available at a later date. These are known as cumulative preference dividends but these are rare.
Preference shares occupy a unique position in the spectrum of ‘cheaper finance but higher risk of bankruptcy for the company’ to ‘expensive finance but lower risk for the company’.
How many preference shares are available to invest in?
Preference shares are an uncommon form of financing and therefore there is only a handful that are available to buy on the UK stock market. Here is a non-exhaustive list:
List of UK preference shares
|Preference Share||Ticker Symbols or ISIN:|
|Aviva 8.375% Prefs||GB0002114154|
|Aviva 8.75% Prefs||GB0002124963|
|BP 9% Prefs||GB0001385474|
|Bristol & West Prefs||GB0000510205|
|Bristol Water 8.75%||GB0001257988|
|Ecclesiastical Insurance Prefs||GB0003035382|
|General Accident 7.875%||GB0003692513|
|General Accident 8.875%||GB0003692737|
|Investec Non-Cum Floating Rate Net||GB00B19RX541|
|Lloyds 6.475% Prefs||GB00BO7VJX10|
|Lloyds 9.25% Prefs||GB0030587611|
|Lloyds Banking Net Non-Cum 9.75%||GB00B3KSB238|
|N Elec 8.061% Prefs||GB0006546898|
|NatWest 9% Prefs||GB0006227051|
|R.E.A Holdings Net Cum||GB0007185639|
|Standard & Chart 7.375% Prefs||GB0008401324|
|Standard & Chart 8.125% Prefs||GB0008399700|
|Sun Alliance 7.375% Prefs||GB0008631391|
What is the running yield on preference shares?
The running yield is calculated as the expected preference dividend (annually) divided by the current market price of the share. Where the buy and sell price differs significantly, use the buy price. This ratio helps investors understand what preference dividend yield they could expect to see if they invested.
The running yield of a preference share is different from the % advertised in the name of the issuance because while the preference dividend amount may remain the same each year, the market price of the shares will have risen or fallen since original issue will change the running yield.
To a preference share investor, only running yield matters. The official % in the preference share title is only a historical piece of information that shows the running yield at the date of issue.
At the time of writing, the Lloyds 9.25% Prefs (ISIN GB0030587611) had a running yield of 5.43%. The BP 9% Prefs (ISIN: GB0001385474) had a running yield of 4.63%.
Why are running yields usually lower than at issue?
Running yields have fallen since the issue of most preference shares because of two factors:
Interest rates, and therefore expected returns fell to historic lows in the decade from 2010 – 2020 which made preference dividend yields very desirable. This attracted investors which pushed up the price of preference shares until the running yield was no longer more attractive (for the risk) than other investments.
Some companies have become more financially stable and therefore lower risk than when they originally issued preference share capital. As investors view the investment as a lower risk, the value of these preference shares has increased accordingly, reducing the flat yield.
This can go the other way around. During the height of the 2008 financial crisis, the running yield of the Natwest and Lloyds preference shares reached 11% – 12%. This reflected the increased possibility that these banks would be unable to pay their preference dividends (indeed, they ceased payments temporarily). Investors also worried that these banks could possibly collapse or be nationalised in the future.
What are the risks of investing in preference shares?
- The preference dividend could be halted due to insufficient profits
- The company could cease to trade, which would result in the value of their preference shares approaching close to £0.
- The value of preference shares could rise and fall due to changes in investor expectations regarding interest rates and the creditworthiness of the company.
- The selling price for the shares could reduce due to an increase in the bid/ask spread due to low volumes of trading or price volatility. The bid/ask spread is the gap between buying and selling prices on the market.
- Due to the low volumes of trading in preference shares, you could push the market price down if you need to sell a large batch of preference shares at short notice.
Why is the buy and sell price of preference shares so different?
You may notice when researching preference shares that the difference between the buying and selling price of a share is unusually wide.
For example; at the date of writing, the London Stock Exchange quotes the following prices for Investec Non-Cum Floating Rate Net (GB00B19RX541):
To buy: £4.38
To sell: £4.00
Bid/ask spread = £0.38 / £4.38 = 8.7%
In contrast, take a look at the prices of the ordinary shares in Investec plc:
To buy: £320.00
To sell: £319.60
Bid/ask spread = £0.40 / £320 = 0.1%
The reason for this difference is that preference shares are not traded frequently. Therefore, the ‘market makers’ who offer to buy or sell shares are uncertain hold long they will need to hold shares they buy from the public before selling it on. To protect themselves against a fall in the value of the shares while holding, they widen the bid/ask spread to give themselves a buffer of protection.
This has huge repercussions for retail investors looking to invest in preference shares. In the example above, an investor who purchased Investec preference shares today would see an immediate 8.7% loss after purchase. That’s because all UK stockbroker accounts value client holdings based on the best selling price for those assets. As the selling price is 8.7% lower than the price paid for the shares, a loss would be immediately registered.
When buying ordinary shares of highly popularly companies, such as the FTSE100 members, investors don’t often notice the bid/ask spread. Preference share investors must consider it very carefully before investing.
The bid/ask spread impact is a one-off investing cost, therefore its impact is felt less if the shares are held for many years. However, if the shares are bought and sold within the same year, it is difficult to see how an investor could possibly make an overall profit given that the running yield per year is lower than the bid/ask spread.
How to invest in preference shares
Retail investors can invest in preference shares through their favourite investing app or stockbroker account, provided that their broker includes these preference shares within their range of investment options. You can often research on a brokerage website before you open an account to check whether they allow clients to buy particular securities.
Buying preference shares is no different to buying the ordinary shares of a company. However, not all brokers will make the full range of preference shares available for investment.
Do preference shares belong in every investor’s portfolio?
As we’ve already highlighted, preference shares are not common and aren’t frequently traded. So the first conclusion we can draw is that preference shares certainly don’t feature in most private investor portfolios. They’re rarely even featured in investing books or books about picking stocks & shares.
This liquidity issue then drives a higher bid/ask spread which makes them less attractive as investments, particularly over shorter-term horizons where the bid/ask spread will be large in proportion to potential income yield.
Where the spread isn’t prohibitively costly, preference shares may find their way into broader income portfolios of dividend-paying shares.
It is probably unwise to view preference shares as an entirely different asset class to dividend shares because it’s such a niche shortlist of instruments. You would have to buy almost every preference share available to diversify risk across a group of 20+ assets, which is recommended for an asset class.
However, as you will see from the list of preference shares above; you’ll see that the UK market is very skewed towards financial institutions and therefore it isn’t possible to balance a UK-only preference share portfolio across sectors.