Features

Preferred stock may include certain features - built-in characteristics that affect how the security works. The issuer chooses these features before the preferred shares are issued, and each one affects how marketable the shares are. Once a feature is set at issuance, it stays in place for the life of the preferred stock. Some features benefit stockholders, while others benefit the issuer.

At issuance (in the primary market), features that benefit stockholders generally make the preferred stock more marketable. That can allow the issuer to offer a lower dividend rate. After issuance, stockholder-beneficial features tend to increase secondary market demand, which pushes prices higher and yields lower.

Features that benefit the issuer generally make the preferred stock less marketable. That may require the issuer to offer a higher dividend rate at issuance. After issuance, issuer-beneficial features tend to reduce market demand, which leads to lower prices and higher yields. Keep this relationship in mind as we work through the characteristics below.

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 cases, dividends are paid in full and on time. However, a company with financial problems may skip or temporarily suspend dividend payments. Dividends are not a legal obligation of the issuer, so they are not required to be paid.

So why do investors expect preferred stock issuers to pay dividends? Skipping dividends can seriously damage an issuer’s reputation in the capital markets. It signals financial weakness and can make it harder to sell additional securities in the future. Many issuers return to the markets regularly to raise capital, so maintaining credibility matters. Still, an issuer can only pay dividends if it has the funds.

Whether a preferred stock is cumulative or straight (non-cumulative) determines what happens if dividends are skipped:

• Cumulative: missed dividends must be paid to preferred stockholders at some point.
• Straight (non-cumulative): missed dividends do not have to be made up.

Preferred stock is “preferred” because it has priority over common stock for dividends. Before an issuer can pay a dividend to common stockholders, it must first make all required payments to preferred stockholders. Consider 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 a 3% dividend (instead of 5%)

Now assume ABC Company becomes more profitable and wants to pay a dividend to common stockholders in 2023. Here’s how the required preferred dividend payments differ for cumulative vs. straight.

Cumulative

The company must make up past skipped dividends and pay 2023’s dividend to preferred stockholders before paying any common stock dividend.

• 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. It only must pay 2023’s preferred dividend 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 this example, it’s the difference between a $17 per share payout and a $5 per share payout. With 100 shares, that difference becomes $1,200 ($1,700 vs. $500).

Because cumulative preferred stock is more desirable to investors, it can often be offered in the primary market with lower dividend rates. It also tends to be in higher demand in the secondary market, resulting in higher prices and lower yields. Non-cumulative preferred stock is less desirable, so it may need to be offered with higher dividend rates. Straight shares also tend to have lower secondary market demand, resulting in lower prices and higher yields.

Participating

Assume you own a $100 par, 5% preferred stock. If the BOD declares the dividend, you earn $5 annually per share. If your shares are participating, you may receive more than the stated dividend rate in a strong earnings year.

For example, in a year with significant earnings, the issuer might pay a 12% dividend (7% higher than the stated 5%). When the issuer’s business is highly profitable, it can pay larger dividends to 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 the investment by paying stockholders a specified amount. For example:

$100 par, 5% preferred stock callable at par

These preferred shares pay regular (typically quarterly) dividends. However, the call feature allows the issuer to redeem the shares in the future. If the issuer calls the shares at par, it pays the investor the par value ($100) and cancels the investment. Once the security is redeemed (called), dividends no longer need to be paid.

This can save the issuer significant money because preferred stock has no maturity date. Without a call feature, the issuer could be committed to paying dividends indefinitely.

Definitions

Redeemed

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

Issuers typically call preferred stock for one of two reasons:

• To stop future dividend payments if they have the funds (similar to paying off a loan early).
• To refinance the preferred stock (the more common reason).

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 first 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 close to 5% at the time. If interest rates later fall to 3%, the issuer has a strong incentive to refinance.

For every share refinanced, the issuer saves $2 annually. If the issuer has one million shares outstanding (which is fairly average), that’s $2 million saved each year.

To refinance, the issuer first issues 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 wouldn’t like this outcome because you lose an investment with a higher dividend rate. If you reinvest the call proceeds into a similar security, you’ll likely end up with a return closer to 3%. This is reinvestment risk, which occurs when reinvested funds earn a lower rate of return.

Call features benefit the issuer, not the stockholder. Some issuers add a call premium and call protection to offset the risk of being called (and to make the security more marketable):

• Call premiums are the amount above par the issuer pays when calling shares.
• Call protection is the period of time before the issuer can exercise the call feature.

Callable shares may have both. For example:

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

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

Even with a call premium or call protection, call features are not beneficial to stockholders. Therefore, issuers typically must offer callable preferred stock with higher dividend rates in the primary market. Callable shares also tend to have lower secondary market demand, 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) tells you how many shares of common stock you receive if you convert. Here, each preferred share can be converted into two shares of common stock. 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 used as a fixed income investment, typically paying quarterly dividend income. Although preferred stock prices can change in the secondary market, relatively few investors buy preferred stock mainly for capital gains (appreciation; buy low, sell high).

Common stock, by contrast, can serve multiple purposes. Some common stock issuers pay regular quarterly dividends (often larger, well-established companies with consistent profitability). All common stock also has capital appreciation potential. Compared with preferred stock, common stock generally has more price volatility and more opportunity for capital gains.

A conversion feature gives preferred stockholders more capital appreciation potential. When the common stock price rises, the value of convertible preferred shares tends to rise as well. Revisit the earlier example:

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

At issuance, the conversion feature is worth $80 because one preferred share can be converted into two common shares worth $40 each. If the common stock price rises to $60, the conversion feature is worth $120 ($60 x 2 shares). The preferred stock would likely trade for at least $120 in the market based solely on its convertibility. If it traded below $120, an arbitrage opportunity would exist.

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, issuing convertible securities is a dilutive action for 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:
  • Higher market prices
  • Lower dividend rates
  • 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:
  • Higher market prices
  • Lower dividend rates
  • 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:
  • Higher market prices
  • Lower dividend rates
  • 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:
  • Higher market prices
  • Lower dividend rates
  • Lower yields

Conversion ratio

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