What is preferable to an ordinary share?

News coverage of the financial markets tends to focus on "ordinary" shares and occasionally on bonds. But current market volatility is throwing light on some great opportunities in a far less well-known investment class: the preference share.

What are preference shares?

Preference shares occupy a niche between corporate bonds (company IOUs used to raise money) and ordinary shares. Like many bonds they pay a fixed, rather than variable, return in the form of a dividend typically in two instalments. So, for example, the "National Westminster 9% preference" pays 4.5p twice a year. The word "preference" reflects the fact that the fixed dividend must be paid before ordinary shareholders receive one in the case of "cumulative prefs", that also includes any dividend arrears (where the company has suspended paying its dividend for some reason). Also, in the event of a liquidation, preference shareholders are entitled to be repaid before ordinary shareholders, although not before bondholders have taken out their cash. In exchange for these benefits, prefs usually have no voting rights at company meetings, just like bonds. Unlike bonds, however, preference shares don't carry a fixed "redemption" date for repayment of capital, unless the issuer has agreed to "call" the shares at a set date in the future.

Why would I buy prefs?

Choose the right preference shares and you could be sitting on a winning investment prefs beat cash deposits and corporate bonds right now, offering a higher yield for only marginally more risk. They're also less risky than ordinary shares, no bad thing given the recent market volatility. On top of this, with many predicting that UK interest rates may start to fall as the economy weakens, investments that pay a fixed income will become even more attractive as the return available on variable rate bank deposits and bonds starts to drop off. As the icing on the cake, they can even be held in your Isa. So why do we hear so little about them? Well, the main barrier to investing in prefs is scarcity. Historically they have only been issued by larger banks and insurers, plus a few industrial firms. As a result, fans tend rapidly to snap up new issues such as the one used recently by RBS to part-fund its bid for ABN Amro. Also, dataon prefs is not as widely available on share-dealing websites as data on ordinary shares. But don't be put off the information can be easily obtained by phoning a broker, who should also be able to buy them for you.

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Which prefs look good right now?

Rik Edwards at broker Collins Stewart likes established issuer Aviva. The Aviva 8.75% pref yields 6.87% (net of stamp duty and basic-rate tax) based on a price of 129.25p, while the 8 3/8% pref yields 6.75%, based on a price of 123.75p. Also competitive at the moment is the Bristol and West 8 1/8%, yielding a meaty 7.37% but with a "non-cumulative" dividend. With this type of preference share, non-payment of some future dividends is a greater possibility, reflected in the yield. Another attractive high-yield pref is the HBOS 6.0884%, yielding 6.55%. A potential bonus is that this one is callable by HBOS in May 2015, meaning the share may be redeemed at its "par" value of £1,000. Based on a price of around £950 per £1,000 "face" value, this will yield 7.3% if redeemed the combination of its annual income yield plus the possibility of a capital gain.

For risk-takers, Breakingviews recommends Northern Rock preference shares, which have fallen by about 20% to around 42p. Mike Verdin speculates that should a successful bidder, such as private-equity financier Chris Flowers, make a play for the bank, these could rebound closer to their pre-crunch price of 90p.