Features

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

• If a feature benefits stockholders, the preferred stock is typically more valuable. Higher value usually means higher demand, which tends to lead to higher market prices and lower yields.
• If a feature benefits the issuer, that feature usually adds risk for investors. Higher risk often means lower demand, which tends to lead to lower market prices and higher yields.

Keep that trade-off in mind as we work through the features below.

Cumulative vs. straight

As discussed above, 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 dividends.

Dividends on preferred stock are not a legal obligation. Even though skipping dividends can harm the issuer’s reputation and make it harder to raise money later, 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: the issuer must pay any skipped dividends to preferred stockholders at some point in the future.
• Straight (non-cumulative): the issuer never makes up skipped dividends.

Preferred stock is “preferred” because it has priority over common stock for dividends. Before an issuer can pay any 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 what the required preferred dividends would look like under each type.

Cumulative

The company must make up past skipped dividends and pay 2022’s dividend to preferred stockholders before it can pay 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 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 paid before any dividend can be paid 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

Cumulative preferred stock is more beneficial to investors when dividends are skipped. In this example, the difference is a $17 per share payout versus a $5 per share payout. With 100 shares, that’s a $1,200 difference ($1,700 vs. $500).

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

This reflects a common finance relationship:

• Added benefits to investors generally mean a lower expected rate of return (compared with a similar security without the benefit).
• Added risks to investors generally mean a higher expected rate of return (compared with a similar security without the risk).

Participating

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

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

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

Participating preferred stock is beneficial to the stockholder, so it tends to:

• sell for higher prices in the market (higher demand)
• trade at lower yields (because higher prices imply lower yields)
• be issued with lower stated dividend rates than non-participating preferred stock

Callable

When preferred stock is callable, the issuer can “take it back” by paying stockholders the par (face) value. A call feature allows the issuer to end the investment.

For example, assume you own a $100 par, 5% callable preferred stock. Callable securities are typically callable at par.

• If the issuer calls your preferred stock, it pays you $100 per share.
• After the call, the shares are redeemed and you no longer receive dividend payments.

This matters because preferred stock has no maturity date. Without a call feature, the issuer is essentially committing to pay dividends indefinitely (as long as dividends are declared).

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:

• The issuer may choose to stop future dividend payments if it has the funds to do so (similar to paying off a loan early).
• More commonly, the issuer calls the shares 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 bought your house, the interest rate you received was largely based on market interest rates. Assuming you had acceptable credit, many buyers at that time were likely getting similar 5% mortgages.

Interest rates play a major role in real estate because interest can add up to a significant amount of money over time (sometimes more than the cost of the home itself).

• If interest rates rise to 8% after you get your loan, your 5% mortgage looks attractive. Your monthly payment would have been higher if you had waited.
• If interest rates fall, you may consider refinancing. For example, if rates drop from 5% to 3%, it can be appealing to pay off the old, higher-rate mortgage and replace it with a new, lower-rate mortgage. Refinancing can involve upfront costs and paperwork, but it may save substantial money over time.

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

If interest rates fall to 3%, the issuer has a strong incentive to refinance its preferred stock. A common approach is:

1. The issuer sells new preferred shares with a dividend rate aligned with current rates (3%).
2. The issuer uses the proceeds to call the older $100 par, 5% callable preferred stock.

As a 5% preferred stockholder, this is unfavorable. You lose a higher-dividend investment, and if you reinvest the call proceeds, you’ll likely find similar preferred shares yielding around 3%.

A call feature is therefore beneficial to the issuer, not the stockholder. To make callable preferred stock more marketable, issuers often provide call protection.

• Call protection is the period during which the security cannot be called. For example, if preferred stock is issued today but can’t be called for 10 years, it has 10 years of call protection.

Additionally, the issuer may offer a call premium.

• A call premium means the issuer pays more than par to call the shares. The higher the call premium, the less attractive it is for the issuer to call the shares.

Even with call protection and/or a call premium, callable preferred stock is still less favorable to stockholders than non-callable preferred stock. Because of this added risk, callable preferred stock is typically issued with higher dividend rates to compensate investors. In the market, callable securities also tend to trade at lower prices and higher yields.