Preferred stock features

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.

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.

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’d 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.