Preference Shares

Most UK banks have issued preference shares in the past decade or so as a way of getting Tier One capital "on the cheap". Preference shares participate in Tier One because the dividends are technically optional - if the bank does not pay them, it is not bankrupt. Until recently no bank contemplated skipping a payment no these instruments.

Preference shares differ from ordinary shares in several ways:

• They pay a predictable dividend (usually fixed, but it can be floating based on e.g. LIBOR).
• Often the issuer can only skip dividends on preference shares in certain clearly delimited circumstances, e.g. the bank has made no profit, or has insufficient capital reserves.
• If the issuer skips the dividend on its preference shares, it cannot pay a dividend on its ordinary shares (and often its behaviour is restricted in other ways, e.g. it may not be permitted to buy back shares).

During the financial crisis of 2008/2009 the price of preference shares plummeted. They faced a number of risks:

• Nationalization/bankruptcy of the issuer. In those circumstances the preference shares would likely be worthless.
• The issuer skipping dividend payments for one or more years.

I initially bought LLPF, issued by Lloyds Banking Group, at a running yield of over 20%. That did well, and more than doubled in value. Lloyds then offered holders of its preference shares a swap for either cash, Lloyds ordinary shares, or "Enhanced Capital Notes" - a form of Contingent Capital (CoCo). At this point I attempted a cunning maneuvre, sold my LLPF shares and bought LLPC, a different issue, instead. LLPC was priced as if it was certain not to qualify for the offer (it sat well below LLPF in the priority list) but I thought it had a decent chance. Sadly LLPC missed out by a gnat's whisker - and I still hold it. It will pay no dividends until 2012, but even taking that into account it offered a yield slightly above 10%, so was worth holding.