Callable

When preferred stock is callable, the issuer has the right to “take it back” from investors. A call feature lets the issuer end the investment by paying stockholders the stock’s par (face) value. For example, suppose you own a $100 par, 5% callable preferred stock. When a security is callable, it’s typically callable at its par value.

If the issuer calls your preferred stock, they pay you $100 per share you own. After the preferred stock is called, the investment is redeemed and you’ll no longer receive dividend payments. This feature can save the issuer significant money because preferred stock has no maturity date. In other words, unless the issuer calls the shares, they’re essentially committed to paying dividends indefinitely.

Issuers typically call their preferred stock for one of two reasons:

• To stop future dividend payments if they have the cash available. This is similar to paying off a loan early when you have enough money on hand.
• To refinance the preferred stock (the more common reason).

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 2%, the issuer has a strong incentive to refinance the preferred stock. A common approach works like this:

• The issuer issues new preferred shares at the current market rate (2%).
• The issuer then calls the older $100 par, 5% callable preferred stock, using the proceeds from selling the new 2% preferred shares.

From the perspective of a 5% preferred stockholder, this is a bad outcome: you lose an investment with a high dividend rate. If you reinvest the $100 call proceeds, you’ll likely have to accept preferred shares yielding around 2%.

A call feature is therefore beneficial to the issuer, not the stockholder. Because of this, issuers typically offer some form of call protection. Call protection is the amount of time before a security can 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. Call protection helps make callable preferred stock more marketable.

In addition, the issuer may offer a call premium if the shares are called. A call premium means the issuer pays some amount above par when calling the shares. The higher the call premium, the less attractive it is for the issuer to call the stock. Call premiums are another way to provide investors some protection.

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