Preferred stock

Similar to common stock, preferred stock is an equity security that represents ownership in a company. However, investors utilize preferred stock in a different way. In particular, capital appreciation (capital gains, growth, buying low & selling high) is not a commonly-cited benefit associated preferred stock investments (although possible to obtain). In particular, cash dividends are what make them valuable.

Cash dividends & par value

Some common stocks pay cash dividends, while some do not. As we learned earlier in this unit, dividend payments depend on the size and overall goals of the company. However, you can safely assume all preferred stocks pay dividends, and their dividend rates are the primary benefit provided to investors. The rate is fixed (never changes) when the security is sold in the primary market by the issuer, which is why preferred stock is considered a fixed income security. This is different than common stock, where dividend rates fluctuate over time.

Preferred stocks typically pay cash dividends on a quarterly basis, but you could encounter preferred shares paying annual or semi-annual dividends. Similar to common stock, the Board of Directors (BOD) must approve the dividend payment when the time comes for a dividend payment to be made. If the company does not have the funds to make the payment, the BOD can vote to skip or indefinitely delay dividend payments. This presents a risk to investors, which we’ll explore further in the suitability chapter later in this unit.

Like any other security, issuers sell preferred stock to raise capital (money) from investors. At issuance, a par value is assigned to the stock. Also known as the face value, par value is what the dividend rate is based upon. For example:

An investor purchases 100 shares of a $100 par, 5% preferred stock. What is the annual amount of dividends received?

Can you figure it out?

All forms of stock have a par value, including common stock. However, common stock par values are relatively insignificant figures that only matter for accounting purposes. Par value for preferred stock is very important. The amount of annual dividends received, which is the primary purpose for a preferred stock investment, is based on par. The typical par value for preferred stock is $100, and you should assume this par value if not specifically mentioned in exam questions. However, you could see other various par values, including $25 and $50.

Let’s see how a difference in par value could affect the payout:

An investor purchases 100 shares of a $25 par, 5% preferred stock. What is the annual amount of dividends received?

Everything in the previous two examples was the same except for the par value, which results in different overall payouts. Be careful and pay attention - NASAA test writers like to be tricky. Assume the par value is $100 if not specifically stated, but don’t assume this is always the case.

Yield

At issuance (when first sold to investors by the issuer), preferred stock is typically sold at par. Once it trades in the secondary market, its market price will fluctuate, which directly affects its yield. Typically tied to bonds, yield is a term to describe the overall rate of return on an income-producing investment. The dividend rate of preferred stock tells the investor what percent of par they receive during cash dividend payouts. A 5%, $100 par preferred stock pays $5 in cash dividends annually. 5% is the dividend rate of the preferred stock, but it isn’t necessarily the yield.

The yield of an investment involves all aspects of return. Specifically, it factors in the price paid for the investment, while the dividend rate does not. Remember, par value is static and never changes, while the market price of the preferred stock can be higher or lower than par depending on demand. If a $100 par preferred stock is bought in the market for $95, then its dividend rate is different than its yield.

Assume the following:

An investor purchases a 5%, $100 par preferred stock for $95

Dividend rate:

• Always based on par
• Dividend rate formula

  • $\text{DR}=\frac{\text{annual\hspace{0.33em}income}}{\text{par}}$

  • $\text{DR}=\frac{\$5}{\$100}$

  • $\text{DR}=5.00\%$

• Never changes

Yield:

• Based on the dividend rate and the price paid for the stock
• Current yield formula

  • $\text{CY}=\frac{\text{annual income}}{\text{market\hspace{0.33em}price}}$

  • $\text{CY}=\frac{\$5}{\$95}$

  • $\text{CY}=5.26\%$

• Fluctuates depending on the market price

As you can see, yield is a more accurate representation of the investor’s return. If they purchase preferred stock in the market for $95 and receive $5 in annual dividends, they’re really receiving a 5.26% return based on the amount of money invested in the preferred stock.

Now, let’s compare yields with varying market prices.

An investor purchases a 5%, $100 par preferred stock

What’s the current yield if purchased for $100?

And for a market price of $105?

As you can see, the higher the price of the preferred stock, the lower the yield. We utilized current yield, which shows the yield based on the current market price. No matter the situation, the investor will receive $5 annually in dividends. The more they have to pay for the preferred stock, the lower their overall rate of return (yield) is.

Finance professionals tend to discuss market prices in generalities. If a preferred stock is selling at a price below its par value, it’s selling at a discount. If a preferred stock is selling at a price above its par value, it’s selling at a premium. If a preferred stock is selling exactly at par value, it’s not selling at either a discount or premium.

There are a number of variables that factor into the market price of preferred stock, but the main influence is interest rates. Although preferred stock doesn’t pay interest (interest relates to borrowed money), its market price is heavily influenced by interest rate changes. The dividend rate of preferred stock is very similar and closely tied to interest rates. To fully understand this, we’ll need to discuss bonds for a moment.

Bonds are securities (investments), just like preferred stock. They have a par value, trade at discounts and premiums, and have a fixed payment rate. When an investor purchases a bond from an issuer, they are paid interest over the life of the bond. Essentially, the investor is lending their money to the issuer in return for interest payments.

When preferred stock is sold by an issuer, the issuer will consider the interest rate environment. Issuers of preferred stock know they are competing with bond issuers for capital (money). If the average interest rate is 5%, a preferred stock issuer would have a tough time selling a 2% preferred stock. Why would an investor purchase a preferred stock with a 2% dividend yield when they can purchase a bond with a 5% interest yield?

Let’s walk through an example to fully understand how interest rate changes affect preferred stock market prices.

Assume the following:

An investor buys a newly issued 5%, $100 par preferred stock at par.

It can be assumed the average interest rate at the time of issuance was close to 5%. At issuance, preferred shares are typically sold at par with a dividend rate that reflects current interest rates. Afterward, it trades in the secondary market. The par value ($100) and the dividend rate (5%) stay fixed and do not change. The market price, however, fluctuates over time.

If interest rates rise to 7%, the 5% preferred stock isn’t as valuable as it once was. If the investor were to attempt to sell their preferred stock for the original price ($100), it would be difficult to find a buyer. With a market interest rate of 7%, investors know they can easily purchase a brand new 7% bond or preferred stock. Why would anyone want the 5% preferred stock?

Lowering the market price makes the 5% preferred stock investment more attractive to potential buyers. When the price of a fixed income investment falls, its yield (overall rate of return) rises.

An investor buys 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates rise to 7% and the investor attempts to sell the stock for $70 per share. What is the current yield for the investment?

$\text{CY}=\frac{\text{annual income}}{\text{market\hspace{0.33em}price}}$

$\text{CY}=\frac{\text{\$5}}{\text{\$70}}$

$\text{CY}=7.14\%$

By lowering the price of the preferred stock, the yield went to 7.14%, which is now greater than the current market interest rate of 7%. The 7.14% yield would be the overall rate of return for the potential investor buying the stock at $70. Because the yield is higher than the average interest rate, the preferred stock is very marketable and will likely be sold. This is why fixed income market values fall when interest rates rise.

Let’s take a look at what happens when interest rates fall.

Assume the following:

An investor buys a newly issued 5%, $100 par preferred stock at par when interest rates are averaging 5%. A few years later, interest rates fall to 3%.

In this environment, the 5% preferred stock is very valuable. The investor owns an investment that pays $5 annually per share, while other investors purchasing new $100 par preferred stock today are receiving $3 (3%) per share annually.

The investor could easily ask for more money than their original investment of $100. With a market interest rate of 3%, investors know the 5% preferred stock is valuable. If they offered to sell their shares for the original $100 purchase price, it would be sold immediately. Due to the demand for the preferred shares, the investor can raise their asking price. By doing so, they’re able to obtain a capital gain and increase their overall return on the investment.

Let’s take a look at what happens to the yield of the preferred stock if they raise the price.

An investor buys 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates fall and the investor attempts to sell the security for $150 per share. What is the current yield?

Can you figure it out?

As we’ve learned, market price fluctuations directly influence preferred stock yields. The lower the market price, the higher the overall rate of return for the investor. The opposite applies too; the higher the market price, the lower the overall rate of return. Yield is a measure of a preferred stock’s overall return.

Settlement

When an investor buys or sells shares of preferred stock, the settlement timeframe is the same as common stock. Regular way trades settle in one business day (T+1), while cash settlement trades settle the same day (as long as before 2:30pm ET).

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 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 has 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.

Key points

Preferred stock characteristics

• Form of ownership (equity)
• Market prices are influenced by interest rates
• Considered a fixed income security

Preferred stock settlement

• Regular way: T+1
• Cash: same day if prior to 2:30pm ET

Preferred stock dividends

• Must be approved by the BOD
• Typically paid on a quarterly basis

Preferred stock par value

• Also known as face value
• Typically $100 for preferred stock
  • Could also be $25 or $50
• Never fluctuates
• Dividend rate based on par

Yield

• Represents overall rate of return
• Based on market price and dividend rate
• Continually fluctuates
• Yield and market price are inverses
  • Low market price = high yield
  • High market price = low yield

Current yield formula

• $\text{CY}=\frac{\text{annual\hspace{0.33em}income}}{\text{market price}}$

Fixed income market prices

• Discount = trading below par
• Premium = trading above par

Rising interest rates

• Fixed income market prices decline

Falling interest rates

• Fixed income market prices increase

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