Along with quality fixed income instruments, the preference or preferred share are the issuance du jour in the markets. Paying a set dividend of well above the  prime rate (most recently issued bank preferred shares are now paying between 6- 6.25% per annum until their reset date) and not as prone to wide variation in share price, the relative safety of preferred shares over common shares has made the product attractive for institutional and retail investor alike.

But can there be too much of a good thing? Should investors holding dividend paying common shares be worried about a company issuing too many preferred shares?

WHO GETS PAID FIRST?

In the abstract, yes. Preferred shares, as the term implies, have preference to dividends over the common shareholders. In fact, common share holders are last in the priorities of who gets paid. The pecking order is typically (from highest priority to lowest):

1. Government is paid its taxes. It has what is known as a super priority to all other creditors;
2. Senior debt holders (senior because they have the highest secured priority);
3. Subordinated debt holders;
4. Preferred shares. Depending on how a company organizes its financing either the entire pool of preferred shareholders, regardless of series, share equally in priority (known as ranking pari-passu) or certain series of preferred shares have priority over others; and
5. Common shareholders.

Thus, the stickiness of dividends is not derived by a function of the law but from the downside risk of a company cutting or suspending its dividend to its share price and market confidence.

SHOULD COMMON SHAREHOLDERS BE WORRIED?

However, in practicality, the threat of preferred shares crowding out potential dividend increases for common shareholders SHOULD BE small. When a company issues preferred shares, it typically states in its propectus its earnings as a multiple of dividend and interest expenses. The higher the multiple, the more desirable the company since it still has sufficient cushion to pay both interest payments to debt holders and dividends to preferred and common shareholders.

Companies with small multiple should tend to scare off a prudent potential investor of either preferred or common shares. After all, if a company can barely meet its on-going cost of capital obligations, why would you invest in it? It has little margin of error and a default on debt obligations is often the first sign of a company’s end.

Larger preference share obligations will also push up the dividend payout ratio. Most shrewd dividend investors would know that a higher than industry average dividend payout ratio would likely result in lower proability of future dividend increases (once again, look at payout ratio and not just yield).

Instead, the larger threat to common shareholders may be conversion of preferred shares into common shares. As part of the bailout package, the American government has the right to convert all the preferred shares it had invested in banks into common shares if banks did not meet the bank stress test (the justification being that it would increase the asset to common equity ratio; a key ratio of a bank’s health).

The potential conversion was criticized for a myriad of reasons (converting shares to prop up financial ratios does not fix the situation, the government would be nationalizing banks etc.) which seems to have died down somewhat given the results of the bank stress test and the market’s desire to recapitalize the banks.

But it does highlight a potential issue for having too many preferred shares. If a company which has issued many preferred shares hits a bump in the road, resulting in the multiple of earnings to interest and dividend obligations decreasing, it could, if it gave itself this option in the prospectus, convert the preferred shares into common shares.

The result would be that the company moves from a contractual obligation to pay preference shares dividends to a discretionary obligation to declare dividends to common shareholders. With many more common shareholder mouths to feed, the company could slash or suspend the dividend to hoard cash. In essence, conversion allows a company to move junior debt-holders (which preferred shares are often described as) to an equity position and then cramp down on the equity holders by slashing the dividend.

How realistic is this possibility? I would hazard to guess remote but if we enter into a “W” shaped recovery (a double recession) who knows?

WHAT SHOULD I LOOK FOR?

The larger moral of the story is if you are looking to purchase preferred shares or are a nervous common shareholder, read the prospectus of a preferred share issue to determine the following:

1. What cushion does an investor have that dividends and debt obligations can be paid (usually look at the “Earnings Coverage” section)?
2. What priority does this series of preferred shares have over other series of preference shares and classes of common shares?
3. What are the conversion rights of the company or the shareholder?

Most preferred shares prospectus are issued as short form prospectus so they run in 10-20 pages rather than 80-100 plus pages. Here is an example of what a preferred share prospectus looks like. Good luck.