The ownership interest in a corporation or financial asset is divided into two types of shares namely common shares and preference shares (also known as preferred stock). Common stock involves dividend payment to shareholders only when company earnings enough profits post accounting for tax, debt payment and reserves. On the other hand, all the preference shares have a pre-set dividend rate, which may be fixed or floating as per the terms stated. Preference shares could be redeemable on the predefined maturity date, or irredeemable without any maturity date. Holders of preference shares do not get voting rights unlike common stock holders.
For example, a company issues 12% preference share which has a par value of $100. In this case, the preferred stockholder is entitled to receive a dividend of $12 (12% of $100) per share per year.
Hybrid security is a sole financial instrument which offers the features of two or more different types of financial securities. It generally combines the characteristics of debt and equity.
The preference shareholders have characteristics like those of the common shares, like both are equity-based financing tools, and both are entitled to the profits. Like the common shares, the preference dividend is also not tax deductible.
The preference shareholders have two distinguishing features from the common sharesThe first is that in case of the liquidation of the company, the preference shareholders have the priority over the money that is left over. The common shareholders get the remaining money. The second is that the preferred stock has a hand over the treatment of profits of the company in the form of dividends. If the company is not paying the full dividend to the preferred stock, then it is not allowed to distribute any dividends to the common stock. Apart from this, the preference shareholders do not enjoy the right to vote which common shareholders enjoy.
The preference shareholders have characteristics like that of a bond like it has a par value which is equivalent to the face value of the bond and a dividend rate equivalent to the coupon rate of the bond.
However, the preference shares are not the same as the bonds as the company does not have any obligation to make the dividend payments to the preference shareholders whereas in case of debt, if the company fails to pay the interest over the bonds, it will have to face legal consequences for that.
Other types of preference shares such as the convertible preferred stock also have a hybrid element with more intensity. The convertible preference shares give the right to get the shares converted to a common share. The movement in the price of a convertible preferred stock is like both common stock and bond. If the price of preference share goes up, it trades in line with the common stock, and if the price falls, it moves like the bond.
As seen from above, the Preferred stock has similar characteristics of both bonds and common stocks because of which many investors consider it to be hybrid security. Depending on risk appetite and return expectation, preferred stock can prove to be a good investment solution for many investors.
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