Features

Preferred stock features affect how investors value the shares in the market.

• If a feature benefits stockholders, it generally makes the preferred stock more valuable. More valuable securities tend to have higher demand, which leads to higher market prices and lower yields.
• If a feature benefits the issuer, it generally adds risk for investors. Riskier securities tend to have lower demand, which leads to lower market prices and higher yields.

Keep that relationship in mind as we work through the common preferred stock features.

Cumulative vs. straight

As discussed earlier, the board of directors (BOD) must approve any dividend payments to preferred stockholders. Most of the time, dividends are paid as expected. However, if a company runs into financial trouble, the BOD can vote to skip or suspend preferred dividends.

Dividends are not a legal obligation. Even though skipping dividends can damage the issuer’s reputation and make future financing harder, a company can’t pay dividends if it doesn’t have the cash.

Whether preferred stock is cumulative or straight (non-cumulative) determines what happens to skipped dividends:

• Cumulative preferred: the issuer must pay any skipped dividends to preferred stockholders at some point in the future.
• Straight (non-cumulative) preferred: skipped dividends are never made up.

Preferred stock is “preferred” because it has priority over common stock for dividends. Before an issuer can pay a dividend to common stockholders, it must first pay all required dividends to preferred stockholders.

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 work for cumulative and straight preferred.

Cumulative

The company must make up past skipped dividends and pay 2022’s dividend to preferred stockholders before paying any dividend 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 preferred dividend must be paid before any common stock dividend.

• 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 favorable to investors when dividends are skipped. In this example, it’s the difference between a $17 per share payout and a $5 per share payout.

That difference scales quickly. With 100 shares, the gap would be $1,200 ($1,700 vs. $500).

Because cumulative preferred stock is more attractive to investors, issuers can typically sell it with lower dividend rates than straight preferred stock.

This same idea shows up throughout finance:

• Add a benefit for the investor → the security can usually be issued with a lower expected return (all else equal).
• Add a risk for the investor → the security usually needs a higher expected return (all else equal).

Participating

If preferred stock is participating, it can receive dividends above the stated dividend rate.

For example, with a $100 par, 5% preferred stock, you’d normally expect $5 per year per share (assuming the BOD declares the dividend).

If the preferred stock is participating, you may receive more than $5 per year in a strong year. When the issuer has unusually good results, it may pay a larger dividend to participating preferred stockholders.

Participating preferred stock is beneficial to the stockholder. As a result:

• It tends to trade at higher prices (higher demand).
• Higher prices imply lower yields.
• Issuers can often offer lower dividend rates at issuance than they would on non-participating preferred.

Callable

When preferred stock is callable, the issuer can “take it back” by redeeming it. A call feature allows the issuer to end the investment by paying stockholders the call price, which is typically based on par value.

For example, assume you own a $100 par, 5% callable preferred stock. If the issuer calls the shares at par, it pays you $100 per share. Once called, the shares are redeemed and you stop receiving dividends.

A call feature can save the issuer money because preferred stock has no maturity date. Without a call, the issuer may be paying dividends indefinitely.

Definitions

Redeem

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

Issuers typically call preferred stock for one of two reasons:

• They want to stop making future dividend payments and have the cash to do so.
• More commonly, they want to refinance.

Sidenote

Refinancing

You’ve probably heard the term “refinance” in the context of home mortgages. Assume you have a 30-year, 5% mortgage. When you took out the loan, your rate was largely determined by market interest rates at that time.

Interest rates matter because interest can be a large part of the total cost of a loan.

• If interest rates rise to 8% after you get your loan, your 5% mortgage looks attractive.
• If interest rates fall, you may consider refinancing.

For example, if your mortgage is 5% and new mortgages are available at 3%, it may be worth paying off the old loan and replacing it with a new, lower-rate loan. Refinancing can involve upfront costs and paperwork, but it can reduce total interest paid over time.

In short, refinancing replaces an older, more expensive obligation with a new, less expensive one. People, companies, and governments refinance when interest rates fall.

When preferred stock is issued, its dividend rate is based on current market interest rates. If you bought a $100 par, 5% preferred stock, market rates were likely near 5% at the time.

If market interest rates later fall to 3%, the issuer has a strong incentive to refinance:

• The issuer sells new preferred shares at the current rate (3%).
• The issuer uses the proceeds to call the older $100 par, 5% callable preferred stock.

As a 5% preferred stockholder, you wouldn’t like this outcome. You lose a higher-dividend investment and, if you reinvest, you’ll likely be reinvesting at lower prevailing yields.

A call feature is therefore beneficial to the issuer, not the stockholder. To make callable preferred stock easier to sell, issuers often include investor protections:

• Call protection: the amount of time before the security can be called (e.g., 10 years of call protection means it can’t be called for 10 years).
• Call premium: an amount above par that the issuer must pay if it calls the shares.

Even with call protection and/or a call premium, callable preferred stock still favors the issuer. Because of that, callable preferred stock is typically issued with higher dividend rates to compensate investors for call risk. Callable securities also tend to 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. Issuing convertible securities is a dilutive action for common stockholders because conversion increases the number of common shares outstanding.

For example, assume you own 10 shares of a company with 100 shares outstanding, so you own 10% of the company. Now assume the company issues convertible preferred shares that would create 100 additional common shares upon conversion. If conversion occurs, there would be 200 shares outstanding (100 original + 100 new), and your 10 shares would represent 5% ownership. Your ownership percentage was diluted.

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 benefits the stockholder because it adds another potential source of return: capital appreciation.

Preferred stock is typically used as a fixed-income investment, often paying quarterly income. While preferred prices do change, most investors don’t buy preferred stock primarily for growth.

Common stock, on the other hand, is often purchased for capital appreciation. Some common stocks also pay dividends, especially at large, established companies.

Convertible preferred stock gives you the option to exchange preferred shares for common shares. Investors may convert for several reasons, including the chance to profit if the common stock price rises.

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 you how many shares of common stock you receive when you convert. The conversion ratio is set at issuance and does not change. In this example, you receive 4 shares of common stock for each preferred share.

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 that example, the investor profited because the common stock price increased. Convertibility increases potential return, so it’s a benefit to investors. Because of that benefit:

• Issuers can typically sell convertible preferred stock with lower dividend rates than non-convertible preferred.
• Convertible securities tend to trade at higher prices and lower yields in the market.

Convertible preferred stock questions won’t always give the conversion ratio directly, but they will provide enough information to find it. On the Series 6, questions often provide the conversion price instead.

The conversion price is the effective price paid per common share if the preferred stock is purchased at 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:

$\text{CR}=\frac{\text{Par }}{\text{Conversion price}}$

Using this formula, can you find the conversion ratio?

Sometimes, exam questions 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:

$\text{CP}=\frac{\text{Par }}{\text{Conversion ratio}}$

Using this formula, can you find the conversion price?

Now, let’s work through a more challenging question 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
• $\text{CR}=\frac{\text{Par }}{\text{Conversion price}}$

Conversion price

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