The Securities & Exchange Board of India (Sebi) recently allowed listing of two hybrid instruments, that is, those that have features of both equity and debt, on exchanges. Trading in non-convertible redeemable preference shares and privately-placed redeemable preference shares, experts say, will give people one more liquid investment option.QUALITY CHECK
"This will bring transparency in raising of funds through non-convertible preference shares and create a market for these securities," says Subir Saha, executive vice president, ICICI Securities.
Preference shares are securities issued by a company that do not carry voting rights like ordinary shares. However, they entitle their holders to a fixed dividend and have a set tenure, after which the company redeems the principal. Holders of preference shares get priority over those who own ordinary shares if the company is wound up. Preference shares can be convertible (into ordinary shares) as well as non-convertible.
Sebi has recently allowed listing of non-convertible redeemable preference shares, that is, those that are not convertible into equity shares and are redeemed at maturity. Listing will give investors the option of exiting early rather than waiting for the instrument to mature.
"Preference shares are not popular due to lack of liquidity. Once they start trading, there will be more buyers," says Raghvendra Nath, managing director of Ladderup Wealth Management.
Sebi has mandated a rating of AA- and above and three-year tenure for listing. Due to the risk involved, the minimum investment for preference shares is Rs 10 lakh.
"As the minimum size is Rs 10 lakh, these shares are for high net worth individuals, or HNIs, and ultra HNIs," says Ashish Shanker, head of investment advisory at Motilal Oswal Private Wealth Management.
Preference shares do not carry voting rights in most situations. Companies, too, may pay dividend only when they earn a profit. In the cumulative option, if the company does not pay dividend in one year, the holder has the right to the payment the next year.
Preference shares are quasi-debt instruments. "Preference shares combine features of equity and debt. They carry equity risk as the principal is not secured. Also, they entitle holders to a dividend similar to fixed deposit interest and have a set tenure," says Shanker of Motilal Oswal Private Wealth.
Preference shares are offered as part of share capital. The company pays fixed dividend to their holders. In this, they are unlike ordinary shares, where dividend is not fixed. But the biggest plus is that dividend income is tax-free in the hands of investors, though companies pay dividend distribution tax.
PREFERENCE VS NCDS VS TAX-FREE BONDS
As the minimum investment in preference shares is Rs 10 lakh, investors usually compare them with non-convertible debentures, or NCDs, which also pay a fixed rate, besides protecting the principal (unlike preference shares), as well as tax-free bonds, which are long-term but protect both principal and interest. "In the worstcase scenario of liquidation, holders of preference shares are put below NCD holders in terms of claim on assets," says Saha of ICICI Securities.
Hence, dividend on preference shares is higher than what one earns from NCDs and tax-free bonds. But a lot will depend on the rating of preference shares. So, while investing in preference shares, one should look for tax arbitrage along with the risk. Interest income from NCDs is taxed while dividend income from preference shares is not. On the other side, interest from tax-free bonds is not taxed.
Tax-free bonds' tenure usually exceeds 10 years. They are also illiquid. On the other hand, while listing will make preference shares more liquid, they also have the advantage of being redeemed by the issuing company. Also, holders of preference shares are in some cases given preferential allotment during issue of shares.
Before investing in preference shares one should look at the company's past profitability and dividend payouts and how it plans to use the funds from the issue. Nath of Ladderup says rating is crucial. "Credit rating of the company is very important. It will help you understand what kind of company you are investing in and whether it will grow in size and popularity."