Cumulative preference shares or commonly referred to as hybrid shares is one of the most common form of capital raised by Australian banks from retail investors. Bank preference shares by far make up the largest segment of the hybrid market.
Cumulative Preference Shares
Preference shares are a form of hybrid investment which sits in between debt and equity.
Banks like these instruments as they are preferentially treated by the rating agencies like S&P, Fitch or Moody’s as equity in the capital structure but the cost of the capital is lower than pure equity as the returns are fixed based on a Australian bank bill swap rate plus a margin.
For the buyers of the preference shares it is one of the rare instances where they can have access to a liquid fixed income investment in Australia.
But make no doubt that while the returns of cumulative preference shares mirror bonds the risk profile is much closer to equity. This is firstly seen in the amount paid from the preference shares which are really just dividends with franking credit.
The holding rule for preference shares are more onerous where it is required for investors to hold the investment for more than 90 days to qualify for the franking credit.
Preference Share Dividend Formula
Hybrid shares are required to payout a certain amount per the formula agreed at issuance. If a hybrid is called cumulative preference shares then even if there are no cash payment of the dividend in that year, the amount which would’ve been paid is added to a balance and have to be paid out at a later date.
This condition is designed to incentivise the issuer to make the payments in the future as they cannot return capital or pay dividends to the equity holders if any amount is outstanding under the outstanding preferred shares.
The preference shareholders will get paid first on the amount owed for that period and prior period before the bank can pay a dividend.
Non-Cumulative Preference Shares
If the preferred share is non-cumulative this means that there is no such requirement for a catch up in dividend payment if it were to be stopped for some reason. When the payments resume the issuer is only required to pay what is owed for that particular period and any amount that would’ve been paid during the stopped payment period is essentially written off by the preference share investor.