What Are Preference Shares and How Do They Work?
Most stock market conversations revolve around volatile price movements and multibagger returns. However, smart portfolio construction often requires a stabilizer. Preference shares serve this exact purpose. They sit squarely between the safety of fixed-income instruments and the high-growth potential of the stock market, offering a unique proposition for Indian investors looking to balance risk.
What Are Preference Shares?
Preference shares or preferred stocks are hybrid financial instruments issued by companies to raise capital. As the name implies, holders of these shares enjoy specific “preferential” rights over ordinary shareholders.
The most distinct advantage is the priority in dividend distribution. When a company announces profits, it must pay the fixed dividend rate to preferred stockholders before distributing a single rupee to holders of equity shares. Furthermore, if the company goes bankrupt or faces liquidation, preference shareholders have a claim on assets that ranks higher than equity holders, though still below secured creditors and bondholders.
Warning: Do not confuse Preference Shares with Bonds. While both pay fixed returns, preference dividends are paid only if the company makes a profit. Bond interest must be paid regardless of profit or loss.
Key Features of Preference Shares
Understanding the mechanics of these shares is crucial before adding them to your demat account. In the Indian context, they operate with specific rules:
1. Fixed Dividends
Unlike common stock where payouts fluctuate with profits, preferred stocks usually carry a fixed rate (e.g., 10% Cumulative Preference Share).
2. No Voting Rights
Generally, these investors cannot vote on company resolutions at the Annual General Meeting (AGM). However, under the Indian Companies Act, 2013, if dividends remain unpaid for two years or more, preference shareholders gain voting rights on all resolutions.
3. Preferential Asset Claim
In a winding-up scenario, capital repayment is prioritized over equity owners.
4. Callable Nature
Most preferred stocks come with a call option, allowing the issuer to buy them back at a specific price after a set period.
Tip: In India, dividends received from preference shares are added to your total income and taxed according to your income tax slab rates. There is no longer a Dividend Distribution Tax (DDT) paid by the company.
Types of Preference Shares
Indian corporate law allows for various structures of preferred stocks to meet different capital needs.
1. Cumulative Preference Shares
If a company faces a loss and skips a dividend, cumulative shares allow unpaid dividends to accumulate as arrears which must be paid later. In contrast, non-cumulative shares forfeit any dividend not declared in that specific year; there is no accumulation.
2. Redeemable Preference Shares
These shares have a definite maturity period. The company repays the principal amount to the investor at the end of the term.
3. Convertible Preference Shares
These offer a route to ownership. After a set period, the investor can convert these shares into equity shares, potentially benefiting from stock price appreciation.
4. Participating Preference Shares
Beyond the fixed dividend, these shareholders have a right to participate in surplus profits remaining after all other dividends have been paid.
Tip: If you are a long-term investor, prioritize cumulative preference shares. This ensures that a few bad years for the company don’t permanently wipe out your income returns.
Advantages of Preference Shares for Investors
For the retail investor, this asset class offers specific strategic benefits:
- Income Stability: They provide a predictable income stream, making them similar to bonds but often with slightly higher yield potential.
- Lower Risk: These shares are less volatile than equities due to their superior asset claims, though they are not completely risk-free.
- Hedge Against Inflation: Participating preferred stocks can offer returns that scale with company profits, providing a partial hedge that fixed bonds cannot offer.
Preference Shares vs Equity Shares
New investors often confuse these two distinct asset classes. While both represent ownership capital, their risk-reward profiles are vastly different. When analyzing equity shares vs preference shares, the distinction lies in control versus security.
| Feature | Preference Shares | Equity Shares |
|---|---|---|
| Dividend Priority | First claim (priority) | Residual claim (last) |
| Rate of Dividend | Fixed | Fluctuating (decided by board) |
| Management Control | No voting rights (generally) | Full voting rights |
| Capital Refund | Priority over equity during liquidation | Last to be paid |
| Arrears | Can accumulate (cumulative type) | Cannot accumulate |
Who Should Consider Investing in Preference Shares?
Preference stocks are not designed for aggressive traders seeking quick capital gains. They are best suited for:
- Conservative Investors: Those who want exposure to corporate India but wish to avoid the daily volatility of the Nifty or Sensex.
- Income-Focused Portfolios: Investors, such as retirees, who prioritize regular cash flow over voting power or massive capital appreciation.
- Diversification Seekers: Adding preferred stocks can lower the overall beta (volatility) of an aggressive equity portfolio.
Warning: A major risk for Indian retail traders is low liquidity. Unlike popular equity shares (like Reliance or TCS), preferred stocks often have very low trading volumes on the NSE/BSE. You might find it difficult to sell your shares quickly at a fair price if you need emergency cash.
Conclusion
Preference shares offer a balanced investment vehicle, combining the fixed income of debt with the ownership structure of equity. They are instrumental for investors who prioritize capital preservation and steady returns over market dominance. However, due to liquidity constraints in the Indian secondary market, they require careful selection.
Before committing capital, you can build a stronger foundation by exploring how different equity types function and compare within the broader market.
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Disclaimer
This article is for educational purposes only and does not constitute financial advice. Trading and investing in the stock market involve risk. Please consult with a SEBI-registered investment advisor before making any financial decisions. Past performance is not indicative of future results.
FAQs
Preference shares are a hybrid instrument offering fixed dividends and priority over equity shareholders. They get paid first during dividend distribution or company liquidation.
These are shares that the issuing company promises to buy back (redeem) from the investor at a fixed price after a set period.
Under the Companies Act, 2013, they must be fully paid up and can only be redeemed using distributable profits or proceeds from a new share issue.
The four primary types are Cumulative (unpaid dividends accumulate), Participating (shares in surplus profits), Convertible (can convert to equity), and Redeemable (repaid at a specific date).
You can buy listed preference shares via your demat account on NSE or BSE, just like regular stocks. However, be aware that they often suffer from low trading volumes.