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Preference Shares — To Buy or Not to Buy

Preference shares, as you would be aware, are a hybrid product. They enjoy some features of the normal equity shares and some of debt. 

Like equity shares, preference shares too are a form of risk-capital and hence not secured. While they do not enjoy any voting rights, companies must first pay dividend to preference shareholders before they can distribute dividend to equity shareholders (subject, of course, to company making adequate profits).  

Like debt, they are entitled to a pre-defined returns in the form of dividend and have a pre-defined tenure. On maturity the preference shares are either redeemed (called Non-convertible Preference Shares) or converted into equity shares (called Convertible Preference Shares). 

While preference shares are not a new product, what is new is the guidelines issued by SEBI recently w.r.t. the 'Issue and Listing of Non-Convertible Redeemable Preference Shares.' This will provide the much-needed liquidity to preference shares. 

Some of the key features of these guidelines are...
...Credit Rating is mandatory and should not be not less than 'AA-'  
...Minimum Tenure is fixed at 3 years
...Listing is mandatory if it is a public offer
...For privately placed preference shares the minimum application size should be Rs.10 lakhs

In practical terms, Non-Convertible Redeemable Preference Shares are very similar to Non-Convertible Debentures (NCDs). In both, you are entitled to a fixed return and on maturity the original investment is redeemed. 

There are, however, two significant differences:
a) The dividend in preference shares will be declared only if the company makes profits, whereas payment of interest on NCDs has no such pre-condition. Also, being unsecured, preference shares will get lower priority than secured NCDs in case of any liquidation. But for this extra risk being borne by the preference shareholders, dividend rates are normally higher than the interest rates on NCDs.
b)  Another advantage is that the tax payable on divided on preference shares is 15%. Whereas interest on NCDs is taxed as per the investor's income slab rate and could be as high as 30%. So HNIs get a tax arbitrage with preference shares.

Profitability of the company is very important if the dividend payments and redemption have to happen in a timely manner. Therefore, the most important thing to consider before investing in preference shares is the quality of the issuing company. As mentioned in an earlier blog '7 reasons why NCD is better than Co. FD', investing in company is risky...very risky. Therefore, you must exercise extensive due diligence and extreme caution before investing in any company.

As regards Convertible Preference shares, it is like investing in equity shares. Therefore, the Promoter, Performance, Prospects, Pricing, Risk and such other parameters as applicable to buying equity shares, must be thoroughly considered when you plan to invest in Convertible Preference shares.

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