Preference Shares vs. Debentures: An Overview
Preference shares and debentures are two different types of financial instruments. Preference shares—also referred to as preferred shares—are an equity instrument known for giving owners preferential rights in the event of a dividend payment or liquidation by the underlying company.
A debenture is a debt security issued by a corporation or government entity that is not secured by an asset.
- Preference, or preferred shares give owners preferential dividend payments and equity rights in liquidation.
- A debenture is a debt security issued by a corporation or government entity that is not secured by an asset.
- Debentures have higher seniority for liquidation repayment than preferred shares, but may pay lower yields.
- The relative level of risk is a primary factor differentiating preferred shares and debentures.
Preference shares are shares of a company's stock issued to preferential shareholders or stakeholders. Like common stock, preference shares represent ownership in a company. Unlike common stock, preference shares usually do not carry any voting power but give the holder of the preference shares claim on a specific quarterly dividend amount and precedence over common stock in the event of a company liquidation.
There are four main types of preference shares that companies may issue:
- Cumulative preferred stock
- Non-cumulative preferred stock
- Participating preferred stock
- Convertible preferred stock
Preference shares are an optimal alternative for risk-averse equity investors. They fall between common equity and corporate bonds on the risk spectrum. Preferred shares can offer a steady flow of dividends similar to an interest payment that is promised to bondholders. Preferred shareholders also rank higher than common stock for liquidation rights, but they still fall after debentures.
Companies agree to pay preferred shareholders dividends before dividends to common shareholders. Provisions can also require preferred share dividends in liquidation and may include special rights for share values in liquidation as well.
Debentures are a corporate or government bond that is not secured by an asset. All types of debentures are bonds, but not all bonds are debentures. Secured bonds fall within a class of their own and can be identified by the collateral associated with the bond.
The structuring of a debenture makes it riskier than a secured debt instrument because collateral does not back it. However, on the risk spectrum, debentures have less risk than preferred shares because of their senior liquidation rights. As a debt instrument, debentures are senior to preferred shares if bankruptcy or liquidation were to occur.
There are two main types of debentures:
- Convertible debentures
- Non-convertible debentures
All debentures follow a standard structuring process and have common features. First, a trust indenture is drafted, which is an agreement between the issuing corporation and the trust that manages the interest of the investors. Next, the coupon rate is decided, which is the rate of interest that the company will pay the debenture holder or investor. This rate can be either fixed or floating and depends on the company's credit rating or the bond's credit rating.
Debentures usually garner a higher interest rate payment than secured debt to offset some of the collateral risks. Each debenture agreement will also detail the seniority of repayment in the event of liquidation. Debenture holders will be paid before preferred shareholders but may be subordinate to other types of debt on the company’s books such as senior loans. If the funds allow, a debenture holder may receive their full repayment of the bond’s principal with interest. Each liquidation is different and will affect the final payout to a debenture holder.
Many investors may have the option to choose between a company’s preferred shares or debentures.
A primary consideration for choosing between preferred shares and debentures depends on risk. Preferred shareholders are typically promised dividend payments and some liquidation rights. However, shares still trade openly on an exchange with the value primarily dictated by the market.
A debenture can be less risky than preferred shares but will also typically have a lower expected return. With a debenture, the owner is promised full repayment of the principal investment plus interest over a specific period. Debentures are also higher on the seniority ranking for reimbursement if a company must liquidate.