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8.3.5 Straight Preferred Shares

Learn about Straight Preferred Shares, their features, market behavior, and benefits for investors. Explore an example to understand yield dynamics.

Straight Preferred Shares

Straight preferred shares are preferred stocks with standard preferences concerning asset and dividend entitlements ahead of common stocks. These shares don’t come with any additional features. They offer a fixed dividend for as long as they remain outstanding, and trade in the market on a yield basis. Similar to bonds and debentures’ market prices, straight preferred shares’ prices are influenced by interest rate fluctuations.

Market Behavioral Pattern

  • If interest rates rise: The fixed dividend payment loses its relative value, causing the market price of straight preferred shares to fall.
  • If interest rates decline: The fixed dividend payment gains more value, leading to an increase in the market price of straight preferred shares.

Example Scenario

A company issues preferred shares with a par value of $50 and a fixed dividend rate of 3% (resulting in an annual fixed dividend payment of $1.50 per share).

  • When interest rates rise, new fixed-income issuers offer higher yields to match the current rates, making the 3% yield on previously issued preferred shares appear too low. Consequently, the price of these shares drops below $50. This price drop offers potential buyers a higher yield, calculated as the dividend divided by the current market price.
  • Conversely, when interest rates fall, the yield becomes more attractive, increasing the market value of the preferred shares above par value.

Characteristics of Straight Preferred Shares

From an investor’s viewpoint, straight preferred shares present the following features:

  • Preference: They offer higher security than common shares due to their prior claim on dividends and assets.
  • Tax Advantage for Individuals: Individuals can benefit from the dividend tax credit.
  • Tax Advantage for Corporations: Corporations can gain a tax advantage, as dividends received from Canadian companies are tax-exempt for them.
  • Less Secure than Debt Investments: Unlike debt investments, dividends on preferred shares are not a legal obligation.
  • No Voting Rights: Preferred shareholders lack voting rights unless dividend payments have been in arrears for a stipulated period.
  • No Maturity Date: These shares don’t have a set maturity date.
  • Marketability: Preferred shares tend to be less marketable than common shares due to their lower issuance volume.
  • Limited Price Appreciation: The appreciation potential is usually capped by the price at which the issuer can redeem the shares.

Key Takeaways

  • Market prices of straight preferred shares fluctuate with interest rates, much like bonds and debentures.
  • They offer advantages in tax liabilities for both individuals and corporations.
  • Straight preferred shares deliver a fixed return, providing security over common shares but with lower foreclosure odds than debt investments.
  • They come with trade-offs like limited price appreciation and no voting rights.

Glossary and Definitions

  • Par Value: The face value of a share, as defined in the company’s charter.
  • Dividend Yield: The annual dividend payment divided by the current market price of the share.
  • Dividend Tax Credit: A tax credit that individual shareholders receive for dividends paid by Canadian corporations.
  • Arrears: Overdue and unpaid dividends.
  • Marketability: The ease with which a security can be bought and sold in the market without affecting its price.

Frequently Asked Questions

Q1: How is the yield of a straight preferred share calculated?

A1: The yield is calculated by dividing the annual dividend by the current market price of the share. For example, if the annual dividend is $1.50 and the current market price is $45, the yield is \( \frac{1.50}{45} \times 100 \approx 3.33% \).

Q2: What factors influence the market price of straight preferred shares?

A2: The main factors influencing the price are broader interest rate movements and supply-demand dynamics in the market.

Q3: Can straight preferred shares be converted into common shares?

A3: No, straight preferred shares typically do not come with conversion features. They are different from convertible preferred shares which can be converted into a specified number of common shares under certain conditions.

Visual Representation

Below is a simple flow to illustrate how interest rates affect the market price of straight preferred shares:

    flowchart TD
	    A[Interest Rates Rise] --> B[Fixed Dividend Less Valuable]
	    B --> C[Market Price Falls]
	    D[Interest Rates Fall] --> E[Fixed Dividend More Valuable]
	    E --> F[Market Price Rises]

CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

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## What is the primary characteristic of straight preferred shares? - [ ] They provide voting rights. - [ ] They have a maturity date. - [ ] They pay variable dividends. - [x] They pay a fixed dividend for as long as they remain outstanding. > **Explanation:** Straight preferred shares pay a fixed dividend and carry normal preferences as to asset and dividend entitlement ahead of common shares, with no other additional features. ## How do straight preferred shares typically trade in the market? - [ ] Based on speculative value - [ ] On book value - [ ] On par value - [x] On a yield basis > **Explanation:** The market price of straight preferred shares trades on a yield basis, similar to bonds and debentures. ## What happens to the market price of straight preferred shares if interest rates rise? - [ ] It remains the same. - [x] It falls. - [ ] It rises. - [ ] It becomes volatile. > **Explanation:** If interest rates rise, the fixed dividend payment becomes less valuable and the market price of straight preferred shares will fall. ## What tax advantage do individuals receive from holding straight preferred shares? - [ ] Capital gains tax exemption - [ ] Higher interest income - [ ] Tax-deferred growth - [x] Dividend tax credit > **Explanation:** Individuals receive a tax advantage through the dividend tax credit for holding straight preferred shares. ## Why might companies find it advantageous to purchase straight preferred shares? - [ ] They offer higher returns than bonds. - [ ] They provide voting rights. - [x] Preferred dividends received from taxable Canadian companies are tax-exempt for corporations. - [ ] They have liquidity preference in times of bankruptcy. > **Explanation:** For corporations, preferred dividends received from taxable Canadian companies are tax-exempt. ## Which of the following is NOT a characteristic of straight preferred shares? - [ ] Fixed dividend payments - [ ] No maturity date - [x] Voting privileges - [ ] Preference over common shares for dividends > **Explanation:** Straight preferred shares do not generally provide voting privileges unless a stated number of dividend payments is in arrears. ## Compared to common shares, straight preferred shares are generally considered: - [ ] More marketable. - [x] Less marketable. - [ ] Equally marketable. - [ ] Not marketable. > **Explanation:** Straight preferred shares are generally less marketable than common shares because there are usually fewer preferred shares outstanding. ## What impact do falling interest rates have on the market price of straight preferred shares? - [ ] The market price remains unchanged. - [ ] The market price falls. - [x] The market price rises. - [ ] The market price becomes more volatile. > **Explanation:** If interest rates decline, the fixed dividend payment becomes more valuable, causing the market price of straight preferred shares to rise. ## Which of the following statements about straight preferred shares is correct? - [ ] They provide absolute safety as dividends are a legal obligation. - [x] They have no maturity date. - [ ] They show unlimited potential for price appreciation. - [ ] They provide voting privileges to all holders. > **Explanation:** Straight preferred shares have no maturity date and provide fixed dividends, but do not inherently grant significant price appreciation potential or voting privileges unless certain conditions are met. ## Which of the following accurately describes a risk associated with straight preferred shares? - [ ] Prices may appreciate significantly beyond redemption value. - [ ] Dividends are a strict legal obligation ensuring payment. - [x] Dividends are not a legal obligation, making them less safe than debt investments. - [ ] They are the most marketable form of securities. > **Explanation:** Dividends on straight preferred shares are not a legal obligation, making them less safe than debt investments.

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