Pref school

Preferred shares may further muddy China's market

Preference is in the eye of the beholder. China's regulators are opening up the market by allowing some companies to issue preferred shares, which carry features of both debt and equity. In a functioning market, that's a useful innovation. In a market like China, however, the risk is that investors see debt and issuers see equity, when the reality is neither.

For companies, there are some obvious benefits to introducing preferred stock. While such paper is generally supposed to pay dividends, companies can cancel or defer payments in tough times without being deemed to have defaulted. The appeal shouldn't be underestimated, especially after the country allowed its first domestic bond default this month, and premier Li Keqiang warned that more failures would be "unavoidable". Meanwhile, investors have largely shunned common equity, which has made the stock market all but useless for capital raising purposes.

Preferred shares should also tick some boxes for investors. They tend to offer higher returns than bonds, to reflect the higher risk. Existing stocks don't offer the same kind of income. Of the 959 companies with shares listed on the Shanghai exchange, just 58 have dividend yields above four per cent, according to Eikon. And, while there's no default protection, preferred shares at least rank before common equity in the queue for repayment following a bankruptcy.

Yet in China's capital market, where risk isn't priced clearly and liquidation is almost unheard of, issuing preferred shares may just muddy things further. Investors may be attracted to something that behaves like debt; issuers may see an instrument that offers the freedom of equity. For investors there's a fallacy of composition too: the more preferred shares a company issues, the more it erodes their appeal relative to common equity.

Banks, which have capital requirements to meet, are likely to be early adopters. There may be future uses for preference shares in cracking open other market reforms, too. It's not unthinkable that the state could convert some of its holdings in the country's biggest companies into non-voting, dividend-yielding stock. But the preference should still be for getting existing types of stock and bond working, rather than adding new ones.