With equity markets turning volatile and showing signs of edginess, buying stocks could eat into your portfolio. If you are looking to invest a tidy sum to earn a fixed rate of return, preference shares may just be what the doctor ordered.

But not every investor can lay his hands on these shares. The ₹10 lakh minimum investment threshold and the fact that these shares are mostly issued through private placement, make it an exclusive investment option for the wealthy.

The easiest way to invest in them is through brokers. Companies do not advertise their preference share issues and hence chances of you getting to know about them are less.

Even so, getting allotment is tough as you have to bid for them in lots and the minimum investment runs into a few crore rupees. Many large brokers who buy these preference shares when they are privately placed, sell them to their clients in smaller lots for investments of as low as ₹10-15 lakh. But before you opt to invest in preference shares, here are a few things you need to know.

Assured dividend

Preference shares pay out dividends to investors at a fixed rate. Companies raise preference share capital mostly through private placement; both institutions and individual investors are eligible to apply for them.

Dividends — paid out of the profits of the issuing company before they are distributed to equity shareholders — are fixed at the time of the issue.

Tata Capital’s preference share issue that closed recently, offered a fixed dividend of 8.33 per cent a year. L&T Finance Holdings’ preference share issue, which closed on May 8, carried a dividend rate of 8.15 per cent.

There are two common types of preference shares — cumulative and non-cumulative. Under cumulative preference shares, the unpaid dividend in a particular year is accumulated and paid to the investor when the dividend is declared. Both recent issues — Tata Capital and L&T Finance Holdings — were cumulative redeemable non-participating preference shares.

Non-participating preference shareholders are entitled to a preferential payment of dividend and liquidation payment (on winding up) and nothing else. They do not have the right to participate with equity shareholders in matters concerning the company. Redeemable means shareholders are paid back their capital at the end of a fixed term — seven years in the case of Tata Capital’s recent preference issue.

But preference shares also carry voting rights. Sharanya G Ranga, Partner, Advaya Legal, says, “Preference shareholders have a right to vote on resolutions which affect their rights.

If their dividends are in arrears for two years or more, they have a right to vote on all resolutions of the company.”

Attractive? Preference shares appeal to rich investors as they give tax-free returns, says Mariam Mathew, Head - Cholamandalam Securities. Dividends on both equity and preference shares are not taxed in the hands of investors, and so the effective pre-tax return is high. “In the case of L&T Finance Holding’s recent offer, the dividend rate was fixed at 8.15 per cent. For an investor in the 30 per cent tax bracket, 8.15 per cent net return is possible only if his investment generates 11.79 per cent pre-tax returns. In debt there are very few options that offer such high returns,” says Mariam Mathew.

If you have exhausted your options with small savings schemes such as National Savings Certificate or even five-year tax-saving deposits, then preference shares that lock into high rates for a long time is a good option to explore.

Risks Preference shares are riskier than bonds, but when compared with ordinary equity shares, the risk is relatively less.

This is because when a company goes belly up, bond holders have the first right on the assets. It is only after the debenture and other debt instrument holders are paid, that shareholders — both ordinary and preferred — get payment of their dues.

But preference shareholders are paid before equity shareholders. Dividends on preference shares are paid based on the company’s profits and not cash flows, says Ashish Shanker, Head - Investment Advisory, Motilal Oswal Private Wealth Management. “Unlike bonds, where the company can pay the assured interest from its cash flows, in case of preference shares it has to necessarily be out of profits. If the company reports loss in a particular year, investors will have to go empty handed.”

So, do not pick up offers of obscure companies that slip into the red every alternate year.

A look into the company’s propensity to pay dividends will also be helpful. Ashish Shanker says, “Tata Capital had a dividend cover of 2.5-3 times at the time of issue.”

Ratings can also provide a clue to the risks in the offer. The Tata Capital offer had CRISIL AA+ rating. L&T Finance Holdings carried a rating of Care AA+. Generally, any rating between AA to AAA can be considered safe, say financial experts.

One big drawback for preference shares is the lack of an established secondary market, unlike tax-free bonds.

If you are buying non-convertible preference shares, you have to wait till the end of the tenure to get your money back.

Related Topics