Features

Preferred stocks may contain certain features, which are characteristics or functions impacting how the security operates. The issuer decides what features will be attached before issuing preferred shares, and each affects the security’s marketability. Once applied at issuance, the feature sticks for the life of the preferred stock. Some benefit stockholders, while others benefit the issuer.

At issuance (in the primary market), features benefitting stockholders make the preferred stock more marketable, potentially allowing the issuer to offer a lower dividend rate. After the security is issued, stockholder-beneficial features create more secondary market demand, resulting in higher prices and lower yields.

Features benefitting the issuer make the preferred stock less marketable, potentially requiring the issuer to offer a higher dividend rate at issuance. After the security is issued, issuer-beneficial features lead to less market demand, resulting in lower prices and higher yields. Keep this in mind as we discuss these characteristics.

We’ll specifically discuss these features in this chapter:

• Cumulative vs. straight
• Participating
• Callable
• Convertible

Cumulative vs. straight

As we learned in the previous chapter, the Board of Directors (BOD) must approve preferred stock dividends. In most circumstances, payments are made in full and on-time. However, a company facing financial problems may skip or temporarily suspend dividend payments. Ultimately, dividends are not a legal obligation of the issuer and are not required to be paid.

You may wonder why investors trust preferred stock issuers to pay dividends. There is one primary reason - skipping dividends is like an issuer shooting themselves in the foot. It demonstrates financial incompetence, making it more difficult to sell additional securities in the future. For context, many issuers offer numerous securities, sometimes consistently to access capital (money) from the securities markets. Think about it - would you buy preferred stock (or any other security) from an issuer with a history of skipping dividends? Probably not. Therefore, it’s in the issuer’s best interest to pay dividends. Regardless, a company can only pay dividends if they have the money.

Whether a preferred stock is cumulative or straight (non-cumulative) determines if the issuer must make up skipped payments. If it’s cumulative, the issuer must pay missed dividends to preferred stockholders at some point. If it’s straight, the issuer will not make up skipped dividends.

Preferred stock is “preferred,” meaning it maintains preference over common stock regarding dividends. For an issuer to make a dividend payment to common stockholders, it must first complete all required payments to preferred stockholders. Assume this example:

ABC Company $100 par, 5% preferred stock

• 2020 - ABC Co. skips their dividend completely
• 2021 - ABC Co. skips their dividend completely
• 2022 - ABC Co. pays 3% of their 5% dividend

Let’s assume ABC Company became more profitable and wanted to make a dividend payment to common stockholders in 2023. Here’s how it would look for both cumulative and straight:

Cumulative

The company must make up past skipped dividends, plus pay 2023’s dividends to preferred stockholders before making dividend payments to common stockholders.

• Required dividend payments

  • 2020: must make up the 5% missed

  • 2021: must make up the 5% missed

  • 2022: must make up the 2% missed

  • 2023: 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. The issuer only must pay 2023’s preferred stock dividends before paying common stockholders.

• Required dividend payments:

  • 2020: will not make up the 5% missed

  • 2021: will not make up the 5% missed

  • 2022: will not make up the 2% missed

  • 2023: 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 more beneficial to stockholders 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 an investor held 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, and therefore can be offered in the primary market with lower dividend rates. Additionally, cumulative shares are in higher demand in the secondary market, resulting in higher prices and lower yields. On the other hand, non-cumulative preferred stock is less desirable, and therefore must be offered with higher dividend rates. Further, straight shares are in lower demand in the secondary market, resulting in lower prices and higher yields.

Participating

Assume you own a $100 par, 5% preferred stock. You would earn $5 annually per share, assuming the Board of Directors elected to pay the dividend. If your shares were participating, you could expect more dividends if the company had a prosperous year. For example, you could be paid a 12% dividend (7% higher than the dividend rate) in a year the issuer reports significant earnings. When the issuer’s business is highly profitable, they pay larger dividends to their participating preferred stockholders.

Participating preferred stock is more desirable to investors, and therefore can be offered in the primary market with lower dividend rates. Additionally, participating shares are in higher demand in the secondary market, resulting in higher prices and lower yields.

Callable

Callable preferred shares can be “taken back” by the issuer. This feature allows the issuer to end an investment by paying stockholders a specified amount. Let’s assume you own the following:

$100 par, 5% preferred stock callable at par

These preferred shares function normally - they pay regular, quarterly dividends. However, the call feature allows the issuer to “take back” the investment in the future. In particular, the issuer can pay the investor their par value ($100) in return for canceling the investment. Once the security is redeemed (called), dividends no longer need to be paid. The issuer can save significant amounts of money utilizing a call feature because preferred stock has no end date or maturity. The issuer is committed to making dividend payments indefinitely unless they call the shares.

Definitions

Redeemed

Occurs when an issuer takes back outstanding securities from investors in return for payment of some form

Issuers typically call their preferred stock for one of two reasons. First, the issuer can avoid making future dividend payments if they have the necessary funds (why not “pay it off” if you can?). This is similar to paying off an outstanding loan early if you have enough money in savings. Second, and more commonly, the issuer can “refinance” their preferred stock.

Sidenote

Refinancing

You’ve probably heard the term ‘refinance,’ most commonly with home mortgages. Assume you have a 30-year, 5% mortgage. When you bought your house, the interest rate you received was largely dependent on market interest rates. As long as you didn’t have a bad credit history, it’s a safe assumption most home buyers were obtaining 5% mortgages at that time.

Interest rates play a huge role in real estate purchases. The interest paid on a home loan can be significant and sometimes is more than the cost of the home itself. When you’re shopping for a home, interest rate fluctuations can significantly influence your future mortgage payments. If interest rates go up to 8% after you obtain your loan, you’ll be pleased with your 5% mortgage. Your monthly mortgage payment would’ve been higher if you had waited!

If interest rates go down, you’ll probably consider refinancing. Going back to our example, let’s again assume you have a 5% mortgage. If interest rates fall to 3%, paying off your older, higher interest rate mortgage would be enticing. To do so, you would take out another mortgage at a lower interest rate (assumptively 3%), and use those funds to pay off the old 5% mortgage. You may encounter some up-front mortgage costs and lots of paperwork, but refinancing could save you significant money over time.

To summarize, refinancing removes older, more expensive obligations, and replaces them with new, less costly obligations. People, companies, and even governments regularly refinance when interest rates fall.

When preferred stock is issued initially, 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. For every share refinanced, they save $2 annually. If the issuer had one million shares outstanding (which is fairly average), they save $2 million every year.

To refinance, they first issue new preferred shares with a dividend rate reflecting current interest rates (3%). Next, the issuer calls the older $100 par, 5% callable preferred stock using the proceeds from selling 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 reinvest the call proceeds back into another similar security, you’ll be stuck with an investment yielding something close to 3%. This is an example of reinvestment risk, which occurs when reinvested funds obtain an investment with a lower rate of return.

Call features are beneficial to the issuer, not the stockholder. Some issuers provide a call premium and call protection to offset the risk of being called (and make the security more marketable). Call premiums represent the amount above par an issuer may obligate itself to pay when calling shares. Call protection represents the time before the issuer can exercise the call feature. Callable shares may maintain both a call premium and call protection. For example:

$100 par, 5% preferred stock callable at 102 after 10 years

These preferred shares maintain a $2 call premium and ten years of call protection. Call premiums are stated on a “percentage of par” basis, meaning they are callable at 102% of the $100 par value (102% of $100 is $102).

Call features are not beneficial to stockholders, even with a call premium or call protection. Therefore, issuers must offer callable preferred stock with higher dividend rates in the primary market. Additionally, callable shares are in lower demand in the secondary market, resulting in lower prices and higher yields.

Convertible

Convertible preferred shares can be exchanged into a specified number of common shares of the same issuer. For example:

$100 par, 5% preferred stock, convertible at a 2:1 ratio

The conversion ratio (2:1 in this example) determines how many shares of common stock are received if converted. This preferred stock can be converted into two shares of common stock for every one preferred share owned. The issuer sets the conversion ratio before offering the security in the primary market. The more common shares received at conversion, the more valuable the conversion feature.

Preferred stock is primarily utilized as a fixed income investment, which typically pays quarterly dividend income. Although preferred stock prices vary in the secondary market, few investors purchase preferred stock for capital gains (appreciation; buy low, sell high). On the other hand, common stock can be a jack of all trades. Some common stock issuers pay regular quarterly dividends, which is typical for larger, well-established companies with consistent profitability. Additionally, all common stock has capital appreciation potential. When comparing the common stock market to the preferred stock market, there’s much more price volatility and opportunity to make capital gains.

Conversion features provide preferred stockholders with more capital appreciation potential. When common stock prices rise, so do the valuations of convertible preferred shares. Let’s re-visit the example above to demonstrate this concept:

$100 par, 5% preferred stock, convertible at a 2:1 ratio
Common stock trading at $40 at issuance

When the preferred stock is issued, the conversion feature is worth $80, allowing one preferred share to be converted into two common shares worth $40 each. If the common stock price rises to $60, the conversion feature is now worth $120 ($60 x 2 shares). The preferred stock would likely trade for at least $120 in the market solely due its convertibility. In fact, an arbitrage opportunity would exist if it traded below $120.

Sidenote

Arbitrage opportunities

Arbitrage involves buying and selling the same investment or security to make an instant profit. Let’s use the example above as a starting point:

$100 par, 5% preferred stock, convertible at a 2:1 ratio
Common stock trading at $60 Preferred stock trading at $110

An arbitrage opportunity exists in this scenario. An investor could purchase a share of preferred stock for $110, convert it into two shares of common stock, and immediately sell them for a total of $120 (2 shares x $60). An investor can earn a $10 gain for every preferred share purchased through arbitrage.

Let’s take a look at a practice question to test your comprehension:

An investor purchases 100 shares of $100 par, 7% convertible preferred stock with a conversion ratio of 4:1 at $95 per share. At the time of the purchase, the common stock is trading at $15. A few years later, the common stock rises to $30. Ignoring the dividend income received, what is the gain or loss if the investor converts and sells the common shares?

Can you figure this one out?

As we discussed in the common stock unit, the issuance of convertible securities is a dilutive action to the common stockholders. Therefore, the issuer must obtain voter approval to issue convertible preferred stock.

Key points

Preferred stock features

• Added characteristics or functions
• Applied at issuance, stay through stock’s life
• Features beneficial to stockholders result in:
  • Lower dividend rates
  • Higher market prices
  • Lower yields
• Features beneficial to the issuer result in:
  • Higher dividend rates
  • Lower market prices
  • Higher yields

Preferred stock dividends

• Must be approved by BOD
• Must be paid before common stock dividends

Cumulative preferred stock

• Issuer must eventually pay skipped dividends
• Beneficial feature for investors
• Associated with:
  • Lower dividend rates
  • Higher market prices
  • Lower yields

Straight (non-cumulative) preferred stock

• Issuer does not pay skipped payments
• Beneficial feature for the issuer
• Associated with:
  • Higher dividend rates
  • Lower market prices
  • Higher yields

Participating preferred stock

• Eligible to receive more than the stated dividend rate
• Issuers pay more in profitable years
• Beneficial feature for the investor
• Associated with:
  • Lower dividend rates
  • Higher market prices
  • Lower yields

Call features

• Allow issuers to end an investment by paying back a specified amount
• Typically exercised when interest rates fall (refinance)
• Beneficial feature for the issuer
• Associated with:
  • Higher dividend rates
  • Lower market prices
  • Higher yields

Call protection

• Number of years before security can be called

Call premium

• Amount above par required to call shares

Convertible preferred stock

• Convertible into common stock of the same issuer
• Beneficial feature for investors
• Associated with:
  • Lower dividend rates
  • Higher market prices
  • Lower yields

Conversion ratio

• Determines how many common shares received at conversion
• Set at issuance and stays fixed