Review
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) is typically not a benefit associated with preferred stock investments. 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 in the previous chapter, dividend payments depend on the size and overall goals of the company. However, you can safely assume all preferred stocks pay dividends, and their fixed 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 section.
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?
Answer = $500
To find the annual dividend paid to the investor on a per share basis, use this formula:
If every share pays $5 in annual dividends, then 100 shares will pay a total of $500 ($5 x 100 shares).
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?
Answer = $125
To find the annual dividend paid to the investor on a per share basis, use this formula:
If every share pays $1.25 in annual dividends, then 100 shares will pay a total of $125 ($1.25 x 100 shares).
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 - FINRA 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
-
- Never changes
Yield:
- Based on the dividend rate and the price paid for a stock
- Current yield formula
-
- 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 the 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.
| Trading at… | Relationship |
|---|---|
| Discount | yield > dividend rate |
| Par | yield = dividend rate |
| Premium | yield < dividend rate |
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?
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?
Answer = 3.33%
When the price increased to $150, the yield of the preferred stock fell. However, it didn’t drop below the current market interest rate of 3%. The preferred stock is still marketable at this price, and the investor could even consider raising the price further. This is why market prices rise when interest rates fall.
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.
Adjustable-rate preferred stock
Although most shares of preferred stock are issued with fixed coupons (dividend rates), some are issued with variable coupons. Adjustable-rate preferred stock (ARPS), sometimes referred to as variable rate preferred stock, have a fluctuating dividend rate that is usually dependent on yields of Treasury bills. T-bill yields are directly tied to interest rate fluctuations, so it could be said ARPS have dividend rates that adjust with interest rate changes.
When interest rates rise, so do the coupons on ARPS, and vice versa. Market values of this type of preferred stock tend to stay very close to par and are much less volatile than non-adjustable shares. Remember, the reason fixed income market values fluctuate is due to their fixed coupons. When interest rates rise, non-adjustable fixed income security market values fall in order to compete with new issue securities with higher coupons. ARPS do not have the same problem; when interest rates rise, so will the coupon on ARPS, resulting in little-to-no reduction in market value.
On the other side, ARPS typically don’t rise much in price when interest rates fall. In this environment, non-adjustable fixed income security values rise as their fixed coupons are more attractive than new securities being issued with lower coupons. Dividend rates on ARPS fall after interest rates decline, resulting in little-to-no increase in market value.
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).
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