Features

Preferred stock features influence their value in the market. If the feature is beneficial to stockholders, it makes the preferred stock more valuable. More valuable securities are in higher demand, which results in higher market prices and lower yields.

If the feature is beneficial to the issuer, the feature is a risk to investors. Riskier securities receive less demand, which results in lower market prices and higher yields. Keep this in mind as we discuss the various features in this section.

Cumulative vs. straight

As we discussed above, the BOD must approve any dividend payments made to preferred stockholders. Normally, every dividend payment is made without question or issue. However, if a company is facing financial problems, the BOD could vote to skip or suspend dividend payments. Ultimately, dividends are not a legal obligation and are not required to be paid. Although it would look bad on the issuer and may have a long-term negative effect on their ability to sell other securities in the future, a company can’t share profits if they don’t have any.

Whether preferred stock is cumulative or straight (non-cumulative) will determine if the company must make up potentially skipped payments. If it’s cumulative, the issuer is required to pay any skipped dividends to preferred stockholders at some point in the future. If it’s straight, the issuer will not make up any skipped dividends, ever.

Preferred stock is “preferred,” meaning that it has preference over common stock when it comes to dividends. In order for an issuer to make a dividend payment to common stockholders, it must make all required payments to preferred stockholders first. Assume this example:

ABC Company $100 par, 5% preferred stock

• 2019 - ABC Co. skips their dividend completely
• 2020 - ABC Co. skips their dividend completely
• 2021 - ABC Co. pays 3% of their 5% dividend

If ABC Co. wanted to make a payment to common stockholders in 2022, here’s how it would look for both cumulative and straight:

Cumulative

The company must make up past skipped dividends, plus pay 2022’s dividend to preferred stockholders before dividend payments to common stockholders

• Required dividend payments

  • 2019: must make up the 5% missed

  • 2020: must make up the 5% missed

  • 2021: must make up the 2% missed

  • 2022: must pay 5% before the common stock dividend

• The company must make a payout total of 17% ($17) to preferred stockholders

Straight (non-cumulative)

The company is not required to make up past skipped dividends; only 2022’s dividend to preferred stockholders must be made before dividend payments to common stockholders

• Required dividend payments:

  • 2019: will not make up the 5% missed

  • 2020: will not make up the 5% missed

  • 2021: will not make up the 2% missed

  • 2022: must pay 5% before the common stock dividend

• The company must make a payout total of 5% ($5) to preferred stockholders

As you can see, cumulative preferred stock is much more beneficial to investors if the issuer skips dividend payments. In our example, it’s the difference between a $17 per share payout and a $5 per share payout. This is only with one share; if you had 100 shares, it would be a difference of $1,200 between the two types ($1,700 vs. $500).

Cumulative preferred stock is more desirable to investors, therefore this type of preferred stock can be sold with lower dividend rates than straight preferred stock. The underlying concept is a generality throughout all of finance: when a security is issued with an added benefit to the investor, the investment can be expected to have a lower rate of return (vs. a similar security without the added benefit), and vice versa. When a security is issued with an added risk, the investment can be expected to have a higher rate of return (vs. a similar security without the added risk).

Participating

If preferred stock is participating, it is eligible for more dividends than the stated dividend rate. If you owned a $100 par, 5% preferred stock, you would presumably earn $5 per year, per share (assuming the BOD elected to pay the dividend).

If the preferred stock was participating, you could expect to be paid more than $5 per year if the company had a prosperous year. When the issuer’s business is successful, they will pay a larger dividend to their participating preferred stockholders.

Participating preferred stock is beneficial to the stockholder, therefore it can be sold for higher prices in the market (more demand). Remember, higher prices mean lower yields. Additionally, issuers sell participating preferred stock with lower dividend rates when they’re originally issued.

Callable

When preferred stock is callable, it can be “taken back” by the issuer. A call feature allows the issuer to end an investment by making a par (face) value payment to stockholders. For example, assume you own a $100 par, 5% callable preferred stock. When a security is callable, it is typically callable at its par value.

If the issuer calls your preferred stock, they will pay you $100 per share owned. After the preferred stock is called, the investment is redeemed and you will no longer receive dividend payments. The issuer can save significant amounts of money utilizing a call feature. Once the security is called, no more dividend payments will be made. Preferred stock does not have an end date or maturity; the issuer is essentially committed to making dividend payments indefinitely unless they call the shares.

Definitions

Redeem

Occurs when an issuer takes back an outstanding security from investors in return for payment of some form

Issuers typically call their preferred stock for one of two reasons. First, the issuer could simply elect to avoid making future dividend payments if they have the necessary funds. This would be similar to paying off an outstanding loan early if you had enough money in savings. Second, and more commonly, the issuer can “refinance” their preferred stock.

Sidenote

Refinancing

You’ve probably heard the term “refinance” before. It’s most common with home mortgages. Assume you have a 30-year, 5% mortgage. When you bought your house, the interest rate you received was largely dependent on market interest rates. As long as you didn’t have a bad credit history, it’s a safe assumption that most home buyers were obtaining 5% mortgages if they bought their homes at the same time you did.

If you have a mortgage, you know interest rates play a huge role in real estate purchases. The amount of interest paid on a home loan can be a significant amount of money (sometimes more than the cost of the home itself).

When you’re shopping for a home, interest rate fluctuations can significantly influence your future mortgage payments. If interest rates go up to 8% after you obtain your loan, you’ll probably be very happy with your 5% mortgage. Your monthly mortgage payment would’ve been higher if you had waited!

If interest rates go down, you’ll probably consider refinancing. Going back to our example, let’s say you have a 5% mortgage. If interest rates drop to 3%, it would be very enticing to pay off your older, higher interest rate mortgage, and replace it with a new, lower interest rate mortgage. It may cost money up front and require a lot of paperwork, but refinancing could save you thousands of dollars over several years.

To summarize, refinancing gets rid of older, more expensive obligations, and replaces them with a new, less expensive obligation. People, companies, and even governments regularly refinance when interest rates fall.

When preferred stock is originally issued, the dividend rate is based on current market interest rates. If you purchased a $100 par, 5% preferred stock, market interest rates were likely very close to 5%.

If interest rates were to fall to 3%, the issuer would have a big incentive to refinance their preferred stock. To do so, the issuer first issues new shares of preferred stock at the current interest rate (3%). Next, the issuer calls the older $100 par, 5% callable preferred stock using the proceeds from the sale of the 3% preferred shares.

As a 5% preferred stockholder, you certainly wouldn’t be happy if this occurred. You just lost an investment with a high dividend rate. If you were to reinvest the call proceeds back into the market, you’ll be stuck with preferred shares yielding 3% on average.

It should be pretty clear that a call feature is beneficial to the issuer, not the stockholder. Because of this, issuers typically provide some form of call protection to their investors. Call protection is the amount of time before a security can be called. If preferred stock is issued today, but can’t be called for 10 years, it has 10 years of call protection. Call protection makes callable preferred stock more marketable.

Additionally, the issuer can offer a call premium if the shares are called. A call premium involves the issuer paying some amount above par to issue the call. The higher the call premium, the less likely a call will occur. These are also used to give investors protection.

Call protection, call premium, or not, callable preferred stock is still not beneficial to stockholders. Due to this, callable preferred stock is issued with higher dividend rates to compensate investors for this risk. Additionally, callable securities trade at lower prices and higher yields in the market.

Convertible

If preferred stock is convertible, it can be converted into common stock of the same issuer. The issuance of convertible securities is a dilutive action to the common stockholders, meaning it affects their proportionate ownership of the company.

To demonstrate this, assume you own 10 shares of a company with 100 shares outstanding, providing you with 10% ownership of the company. Also assume the business decides to issue convertible preferred shares, which result in an additional 100 shares being created upon conversion. If those preferred shares are converted, you now own 10 of the 200 outstanding shares (100 original + 100 new shares from the conversion), or a 5% ownership level. By virtue of the company issuing convertible preferred stock, it diluted your common stock ownership level.

Because dilution negatively affects common stockholders, the issuer must obtain voter approval to issue convertible preferred stock or bonds.

Convertible bonds are discussed in a future section,

Convertibility is a benefit to the stockholder, as it is another way for the investor to make a return - capital appreciation. As we discussed above, preferred stock is primarily utilized as a fixed-income investment, typically paying semi-annual income to its investors. Although the market price of preferred stock varies, very few investors purchase preferred stock for growth. Preferred stock prices are not as predictable or volatile for most investors to seek capital gains (a.k.a. capital appreciation or growth).

Common stock can be a jack of all trades. Some issuers of common stock pay regular quarterly dividends to their stockholders. This is typical for larger, well-established companies with consistent profits. Most common stockholders invest for capital appreciation. When comparing the common stock market to the preferred stock market, you’ll find much more price volatility and opportunities to make capital gains with common stock.

Convertible preferred stock offers the opportunity to transform the investment into shares of common stock. There are several reasons why an investor would consider converting. First, it may be a profitable move. Let’s assume the following:

A $100 par, 5% convertible preferred stock with a conversion ratio of 4:1 is trading at $100 per share.

The conversion ratio tells the preferred stockholder how many shares of common stock they receive if they convert their shares. The conversion ratio is set when the preferred stock is originally issued and does not change. In this example, the preferred stockholder will receive 4 shares of common stock for every preferred share owned.

Back to our example:

An investor purchases 100 shares of $100 par, 5% convertible preferred stock at $100 per share. The preferred shares have a conversion ratio of 4:1, while the common stock is trading at $15. A few years later, the common stock rises to $30. The investor converts their shares to common stock and immediately sells the common stock. What is the gain or loss?

Can you figure this one out?

In the last example, the investor made a profit because the common stock price increased. Convertibility is a benefit for investors, as it provides more potential for return. Therefore, the issuer can sell convertible preferred stock with lower dividend rates than non-convertible preferred stock. Additionally, convertible securities are attractive in the market, which drives higher market prices and lower yields for these types of investments.

Convertible preferred stock questions won’t always provide the conversion ratio, but they must always give enough information to find the conversion ratio. In particular, Series 6 conversion questions typically provide the conversion price instead. The conversion price reflects the overall cost of the common stock (per share) if the preferred stock is purchased for par and converted. For example:

An investor purchases 100 shares of a $100 par, 5% preferred stock convertible at $25. What is the conversion ratio?

The formula for the conversion ratio is:

$\text{CR}=\frac{\text{Par }}{\text{Conversion\hspace{0.33em}price}}$

Using this formula, can you find the conversion ratio?

Sometimes, exam questions can provide the conversion ratio and ask for the conversion price. For example:

An investor purchases 100 shares of a $100 par, 5% preferred stock with a 4:1 conversion ratio. What is the conversion price?

The conversion price formula is very similar to the conversion ratio formula:

$\text{CP}=\frac{\text{Par }}{\text{Conversion\hspace{0.33em}ratio}}$

Using this formula, can you find the conversion price?

Now, let’s dive into some more difficult questions involving convertible preferred stock.

An investor purchases shares of a $100 par, 7% preferred stock which is convertible at $25 and callable at 102. A few years later, the preferred stock is trading at $103, while the common stock is trading at $26. If the issuer announces an upcoming call of the preferred stock in 60 days, which of the following options should you recommend to the investor?

A) Allow the shares to be called

B) Sell the preferred stock

C) Convert to common and sell the shares

D) Continue to hold the preferred stock

Can you figure out the best answer?

Key points

Cumulative preferred stock

• Issuer must eventually pay skipped dividends
• Beneficial feature for investors
• Lower rates of return (vs. straight)

Straight (non-cumulative) preferred stock

• Issuer does not pay skipped payments
• Beneficial feature for the issuer
• Higher rates of return (vs. cumulative)

Participating preferred stock

• Eligible to receive more than the stated dividend rate
• Issuers pay more in profitable years
• Beneficial feature for the investor
• Lower dividend rates (vs. non-participating shares)
• Trades at higher prices and lower yields

Call features

• Allows issuer to end an investment by paying back its par value
• Calls typically occur when interest rates fall
• Beneficial for the issuer
• Sold with higher dividend rates (vs. non-callable)
  • Lower prices & higher yields
• Used by issuers to refinance

Call protection

• Number of years before security can be called

Call premium

• Amount above par required to call shares

Convertible preferred stock

• Convertible into common stock of the same issuer
• Beneficial feature for investors
• Sold with lower dividend rates (vs. non-convertible)
  • Higher prices & lower yields

Conversion ratio

• Determines how many common shares received at conversion
• Set at issuance and stays fixed
• $\text{CR}=\frac{\text{Par }}{\text{Conversion\hspace{0.33em}price}}$

Conversion price

• Price paid per common share if convertible security bought at par
• $\text{CP}=\frac{\text{Par }}{\text{Conversion\hspace{0.33em}ratio}}$