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. More demand tends to push market prices up and yields down.
• If a feature benefits the issuer, that feature usually adds risk for investors. Less demand tends to push market prices down and yields up.

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. But 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. A company can’t distribute profits it doesn’t have. Skipping dividends may hurt the issuer’s reputation and make it harder to raise money later, but it’s still allowed.

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

• Cumulative preferred stock: the issuer must eventually pay any skipped dividends to preferred stockholders.
• Straight (non-cumulative) preferred stock: 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 what would be required under each type.

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 the example shows, cumulative preferred stock is much more favorable to investors when dividends are skipped. Here, it’s the difference between a $17 per share payout and a $5 per share payout.

This difference scales with the number of shares. With 100 shares, the total payout difference would be $1,200 ($1,700 vs. $500).

Because cumulative preferred stock offers investors more protection, it’s typically easier to sell and can be issued with lower dividend rates than straight preferred stock.

This reflects a general finance principle:

• Add a benefit for investors → the security can usually be issued with a lower expected return (compared with a similar security without that benefit).
• Add a risk for investors → the security usually needs a higher expected return (compared with a similar security without that risk).

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 performs well, it may pay additional dividends to participating preferred stockholders.

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

• trade at higher prices (more demand)
• offer lower yields
• be issued with lower dividend rates than non-participating preferred stock

Callable

When preferred stock is callable, the issuer can “take it back” by paying stockholders the security’s par (face) value. In other words, the issuer can end the investment.

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

• If the issuer calls the shares, it pays you $100 per share.
• After the call, the shares are redeemed and you no longer receive dividends.

This matters because preferred stock has no maturity date. Without a call feature, the issuer could 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:

• The issuer wants to stop making future dividend payments and has the funds to do so (similar to paying off a loan early).
• More commonly, the issuer wants 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 interest rate was largely determined by market interest rates at that time.

Interest rates have a big impact on real estate because interest can add up to a large dollar amount over the life of a loan.

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

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

• The issuer sells new preferred shares at the current rate (3%).
• The issuer then calls the older $100 par, 5% callable preferred stock, using the proceeds from the new issue.

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

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. If preferred stock is issued today but can’t be called for 10 years, it has 10 years of call protection.
• Call premium: an amount above par that the issuer must pay to call the shares. A higher call premium makes a call less attractive to the issuer and provides additional protection to investors.

Even with call protection and/or a call premium, callable preferred stock still favors the issuer. Because of that added risk, callable preferred stock is typically issued with higher dividend rates to compensate investors. Callable securities also tend to trade at lower prices and higher yields in the market.