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 2%, the issuer has 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 (2%). Next, the issuer calls the older $100 par, 5% callable preferred stock using the proceeds from the sale of the 2% 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’ll be stuck with preferred shares yielding 2% 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.