Basic characteristics
Preferred stock represents ownership and is an equity security (like common stock), but it acts like a fixed-income security (unlike common stock). This type of security is known for its dividend income, which is typically static (fixed) and does not change. For context, dividend payments from common stock typically fluctuate over time. While only certain companies pay cash dividends on their common stock, all companies pay cash dividends on their preferred stock.
We’ll cover the essentials of preferred stock in this chapter, including:
- Dividends & par value
- Yield
- The market & interest rates
Dividends & par value
Dividend payments attract investors to preferred stock. This type of security makes cash dividend payments typically on a quarterly basis, although some issuers opt for annual or semi-annual payments*. Similar to common stock dividends, the Board of Directors (BOD) must approve the dividend payment.
*In test questions, assume preferred stock pays quarterly dividends unless otherwise specified.
The term ‘par’ is important when discussing fixed income investments like preferred stock and bonds. And no, we’re not talking golf. Par value is sometimes referred to as “face value,” like the face value of a ticket to a concert.
Concert tickets are initially sold at face value, but then are bought and sold amongst concert-goers in the secondary market. If the concert is in high demand and sells out, tickets trade above their face value. If no one knows about the show, tickets trade below their face value. Par values work similarly. When preferred stock is originally issued, it’s typically sold at its par value. You should assume the par value for preferred stock is $100, although it could differ depending on the issuer’s preference (e.g., $25 or $50 par values*).
*In test questions, assume preferred stock par value is $100 unless otherwise specified.
Par value is crucial because it determines the dividends paid to investors. Preferred stock maintains a fixed dividend rate, sometimes called a “coupon*.” The dividend rate is always based on par. For example, assume ExxonMobil issues a $100 par, 5% preferred stock. Shares are sold at par ($100) and will pay $5 every year to their investors (5% of $100). Remember, preferred stock makes payments quarterly, so investors receive $1.25 per share every three months. Regardless of its market price, preferred stock always pays dividends based on par.
*The reason we refer to the income rate of fixed income securities as “coupons” is covered later in this material.
Most preferred stocks are originally issued at par in the primary market. After issuance, it trades in the secondary market. Its market price will depend on demand; the more demand, the higher the price (and vice versa). Regardless, the par value and dividend rate remain the same. Assuming our previous ExxonMobil example, the dividend rate will always be 5% of par ($100), even if the market price fluctuates to $80, $110, or whatever market price. This preferred stock will pay $5 annually, no matter the market price. Par value stays fixed and does not change.
The issuer’s profitability also influences the market price of preferred stock. The primary value of a preferred stock is the dividend payments, so if an issuer isn’t very profitable and isn’t paying as much in dividends, the preferred stock is less valuable, and the market price will fall.
Yield
Yield refers to the rate of return an income-producing security provides. While the dividend rate is based on the unchanging par value, yield is based on the fluctuating market price. Yield specifically factors in the price paid for the investment, while the dividend rate does not. To demonstrate this, let’s assume the following:
An investor purchases a 5%, $100 par preferred stock purchased in the secondary market for $80.
Dividend rate:
- Always based on par
- Dividend rate formula
- Never changes
Yield:
- Based on the dividend rate and the price paid for the stock
- Current yield formula
- Fluctuates depending on the market price
The current yield, also known as the dividend yield, is the primary way investors calculate the rate of return on income-producing securities. It’s called the current yield because it reflects the rate of return based on the current market price. Compared to the dividend rate, it’s a more accurate representation of an investor’s return. In the example above, the investor receives 5% of the $100 par value in dividend payments. However, their personal rate of return (yield) is actually 6.25% because they only paid $80 per share for the investment.
Now, let’s demonstrate how yields change with varying market prices.
An investor purchases a 5%, $100 par preferred stock purchased in the secondary market for $100. What’s the current yield?
And the current yield if the market price of the security is $120?
As you can see, the higher the preferred stock market price, the lower the yield. No matter the situation, the investor will receive $5 annually in dividends. The more they pay for the preferred stock, the lower their overall return rate (yield). And vice versa - the less they pay for the preferred stock, the higher their overall return rate.
Finance professionals tend to discuss market prices in generalities. If a preferred stock trades at a price below par, it’s selling at a discount. If a preferred stock trades at a price above par, it’s selling at a premium. If a preferred stock trades at par value, there is no discount or premium. To quickly summarize these price dynamics and how they relate to yield, here’s what you need to know:
| Trading at… | Relationship |
|---|---|
| Discount | yield > dividend rate |
| Par | yield = dividend rate |
| Premium | yield < dividend rate |
The current yield is an essential formula to remember because it represents a quick and easy way of determining a customer’s overall rate of return.
The market & interest rates
Preferred stock is a negotiable security that trades in the market with fluctuating market prices. The demand for a particular preferred stock determines its market price. It functions similarly to all negotiable securities; the more demand, the higher the price (and vice versa). However, the driving factors behind price fluctuations are not typically the economy or business-related conditions. Instead, preferred stocks are most commonly influenced by interest rate changes. Interest rates are a significant driving force in the financial markets. You probably know them as what you’re paid for depositing money at a bank or what you pay when you take out a loan. An interest rate represents the cost of borrowing money, plain and simple. The reason it’s so important is that everyone borrows money.
Individuals borrow money to make credit card purchases, buy cars, buy houses, put gifts on layaway, purchase cell phones, and fund small businesses. Corporations also borrow money, and lots of it. Whether you know it or not, your favorite restaurant is probably paying off a monthly mortgage or a loan for all of its kitchen equipment. How about that airplane you flew on recently for that fun vacation? The airline probably bought it with borrowed money. And also, the utility company that powers your home? They probably built their power plant with borrowed money. Many businesses are fueled by debt; the more expensive it is to borrow, the lower a business’s profitability. Governments borrow money as well (lots of it). The US Government, for example, is over $33 trillion dollars in debt. Without the power of borrowed money, the government couldn’t fund health benefits for seniors, the military, or federal agencies. State and local governments also borrow significant amounts of money. The roads you drive on, the schools your kids go to, and the parks you visit were likely built with borrowed money.
Although preferred stock does not pay interest (which 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 discuss bonds for a moment.
Bonds are securities (investments), just like preferred stock. They maintain a par value, trade at discounts and premiums, and make semi-annual payments. However, bonds are different because they’re considered debt securities. Investors that purchase bonds in the primary market are essentially loaning money to issuers. In return, investors are paid interest over the life of the bond. Because bonds and preferred stocks have so many similarities, they compete for the same investors. Bond market dynamics must be considered when a corporation plans to issue new shares of preferred stock. If the average bond interest rate is 7%, it would likely be impossible for an issuer to issue a 3% preferred stock successfully. Why would an investor purchase a preferred stock with a 3% return when they can purchase a bond reflecting similar characteristics with a 7% return?
Due to this dynamic, preferred stock issuers and investors pay close attention to interest rate fluctuations. Dividend rates must be competitive, especially because dividends are not legal obligations (interest from bonds is; you’ll learn more about this in a future chapter). In fact, preferred stock dividend rates tend to be higher than bond interest rates due to this dynamic. Plainly stated, preferred stock is generally riskier because dividends are subject to BOD approval.
Once a preferred stock is issued, the dividend rate is fixed. However, its market price is significantly influenced by interest rate fluctuations after issuance.
When interest rates rise
Let’s walk through an example to better 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’s common for preferred stock to be issued at par with a dividend rate that reflects current interest rates. Therefore, let’s assume the average interest rate at the time of issuance was close to 5%. If interest rates rise to 7% later, the 5% preferred stock isn’t as valuable as it once was. An investor attempting to liquidate (sell) this preferred stock for the original price ($100) would have trouble finding a buyer. With a market interest rate of 7%, investors can easily obtain a brand new 7% bond or preferred stock. Why would anyone want the 5% preferred stock?
Good news for the investor - finding a buyer is possible. All it takes is a willingness to lower the market price. This practice works with any product. Having trouble selling something? Just lower the price! When the market price of a fixed-income investment falls, its yield rises for prospective buyers. Let’s demonstrate this concept through an example:
An investor purchases 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates rise to 7%, and the investor attempts to liquidate 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 preferred stock is now marketable and will likely be sold. The only problem is the loss the selling investor takes. Regardless, this scenario depicts why fixed income market values fall when interest rates rise.
When interest rates fall
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%.
The 5% preferred stock is more valuable now that interest rates have declined. The investor owns an investment that pays a 5% return, while other investors purchasing new fixed income securities are obtaining securities with 3% returns on average. The holder of the 5% preferred stock could sell the security at a premium price. If they offer the stock for the original $100 purchase price, it would be snatched up immediately. This scenario shows the primary way a preferred stockholder can obtain a capital gain and increase their overall return.
Let’s look at what happens to the preferred stock’s yield if the market price rises.
An investor buys 100 shares of a newly issued 5%, $100 par preferred stock at par. Interest rates fall, and the investor offers to sell the security for $150. What is the current yield?
When the price increased to $150, the preferred stock’s yield fell. However, it didn’t fall below the current market interest rate of 3%. The preferred stock is marketable at this price, and the investor could even consider raising the price further.
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