The stock market has become fascinated by preferred stocks since the China Securities Regulatory Commission, or CSRC, said it was working on a plan to allow companies to raise capital by issuing this class of shares.

Many analysts attributed the latest rally, at least partly, to the CSRC's move, arguing that the issuing of preferred stocks would enable enterprises, particularly banks, to raise much needed capital without necessarily draining market liquidity. Unsurprisingly, investors are finding such talk reassuring because the prospect of banks, property developers and many other cash-strapped listed companies flooding the market with new issues of common stock has been weighing heavily on their minds for so long.

Some analysts and market commentators have called the introduction of preferred stocks a big leap forward in financial reform. There were those who predicted that the lifting of the ban on preferred stocks, together with improving economic prospects, would banish the long-reigning bear and usher in the bull.

Not so fast, others cautioned. Preferred stocks are not the magic bullet that many investors have been led to believe. They are just hybrid papers that are a cross between common stocks and fixed-income instruments, such as bonds. And it's not clear who would be interested in buying them in the absence of tax or other incentives.

Holders of preferred stocks are entitled to a dividend payout at rate that is fixed at the time of issuance. But because they are not debt instruments, like bonds, the issuers have the option to defer payment of any dividend, or, in some cases, skip it entirely. Although preferred stockholders do enjoy greater protection than common stockholders in the event that the issuing company goes into liquidation.

When the company is doing well, its common stockholders, not preferred stockholders, can stand to benefit from higher dividend payouts and, more importantly, an increase in the value of their investments resulting from rising stock prices.

The yield of preferred stocks, which is in line with the benchmark bank interest rate, is similar to that of same issuing company's bonds. Bond-holders are entitled to a higher level of protection than preferred stockholders in liquidation. What's more, bonds have fixed terms requiring issuers to buy back the instruments at par when the term expires. Preferred stocks have no expiry dates. Holders wanting their money back will have to sell their preferred stocks in the market at prevailing prices.

In some markets, notably the United States, dividend incomes from preferred stocks are exempted from withholding tax. As a result, the returns of preferred stocks are usually higher than the after-tax income of bonds, helping to enhance the attractiveness of this hybrid instrument to institutional investors, including banks looking to boost their tier-one capital base.

CSRC has apparently taken the view that preferred stocks can help solve a pressing issue arising from the strong demand for new capital by domestic banks following the lending binge in the past several years, as well as by many enterprises involved in on-going large infrastructure and other construction projects. The stock market is in no condition to satisfy a cash call of such magnitude. Issuing bonds is not an easy option for the many enterprises that have already run up a dangerously high level of debt.

Supposedly, preferred stocks issued by blue-chip enterprises with promising income streams will provide an alternative choice to institutional and corporate investors who have grown leery of the often unpredictable stock market mood. It's up the CSRC to work with other government agencies to ensure that preferred stocks are a viable choice to those investors.

(China Daily USA 09/30/2013 page11)