Preferred Stock

Preferred stock is not stock. Although usually characterized as such because it pays a dividend and is considered equity rather than debt — since the corporation has no legal obligation to repay the par value of the stock — preferred stock does not represent an ownership interest in the corporation, which is why preferred stockholders have no right to vote for the board of directors except under special circumstances. If the company is liquidated in bankruptcy, preferred stockholders get paid before common stockholders, but only an amount set by contract, usually the par value of the stock. Thus, preferred stock is considered a hybrid security, or even as a form of mezzanine debt.

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The characteristics of preferred stock are specified in the preferred stock contract. Preferred stocks differs from bonds in the following ways:

When corporations issue securities to finance their operation, they issue, in order of issue size, bonds, common stocks, and preferred stocks. Prior to the 1980's, preferred stocks were issued mainly by utilities, but nowadays, the main issuers of preferreds are financial institutions and insurance companies.

Companies issue preferred stock to appeal to investors who want income and greater safety, but issuing preferred stock instead of bonds gives the company more flexibility. If the company is financially stressed, it can skip dividend payments to preferred stockholders, but not to bondholders. Oftentimes, preferred stock is issued when a company is having financially difficulties. It brings in more money at a time when the company needs it, but doesn't obligate the company to future payments in the way that bonds do. Because there is no obligation to pay dividends, the issuance of preferreds will not lower the credit rating of the issuer as an increase in debt would.

Preferred stockholders usually have no voting privileges, but they do have priority for dividends, since, not having an ownership interest as common stockholders do, the dividend is their only return. In the event of liquidation, if there are assets left over after paying creditors, then preferred stockholders will at least get par value of their stock back or a specified amount, plus any dividend in arrears, depending on the preferred stock contract, before anything is paid to common stockholders. Sometimes, preferred stock is issued in classes with different seniority in the event of bankruptcy. First preferred has seniority over all other stockholders, and second preferred is senior to all other stockholders except first preferred. In most company bankruptcies, however, there are no assets, after paying creditors, for either preferred or common stockholders.

Preferred stock is rated by the same nationally recognized statistical rating organizations, such Moody's or Standard and Poor's, that rate bonds. However, the ratings for preferred stock are specific to the issue rather than the issuer. The ratings between the issuer's bonds and preferred stock may differ because a credit rating is used, in part, to determine the probability that the issuer will continue making payments. Because the issuer must make interest payments on bonds, but can suspend payments on preferred stock if financially stressed, it is more probable that interest payments will be made over dividend payments; ergo, the usually higher credit rating for bonds from the same issuer. Generally, most preferred stock is not highly rated, since they are mostly issued by companies under some financial stress.

Callable Preferred Stock

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Although most preferred stock has no stated maturity, most issues have a sinking fund provision, where a certain number of issues, or a certain percentage of the original issue number, is retired periodically, usually annually, by the sinking fund. If prevailing interest rates are higher than the stock's dividend rate, then the fund will purchase the shares in the open market. However, if interest rates are lower, or if not enough shares are available in the secondary market to satisfy the number of shares required, then shares will be selected at random, and a call notice given to the stockholder. Some sinking fund provisions also have a double-up option that allows the issuer to double the number of shares retired within the period. Note that with a sinking fund provision, there is no call premium, and the specified number of shares must be retired regardless of prevailing interest rates.

Even if there is no sinking fund provision, the preferred stock may still be callable, since it benefits the company. It allows the company to call back, or to redeem, a callable preferred stock at a specific price, the call price, printed on the stock certificate. It can also buy back the stock on the open market, and will do so if the current market price is below the call price. Generally, the company cannot call the stock before the call date, it must give adequate notice, and it usually pays a call premium, a small amount above the par value of the stock. If the stock is convertible, then the stockholder can convert the preferred shares into common shares, if it is profitable. The company will most likely call its stock if interest rates decline or if the creditworthiness of the issuer improves, since, then, it will be able to issue new securities with a lower yield.

 If preferred stock is called, then the stockholder is entitled to:

A preferred stock may be called because:

Callable preferred stock, as with other callable securities, exhibits reinvestment risk, because they are more likely to be called when interest rates are lower, making it more difficult to earn the same return by reinvesting the money.

Taxes and Dividends

The main tax advantage is to corporations who purchase preferred stock. Federal tax law allows a qualified corporation to exclude 70% of dividend income received from other corporations from their gross income—referred to as the inter-corporate dividends received deduction (DRD). Therefore, only 30% of the income is subject to federal income tax.

Example — Inter-corporate Dividends Received Deduction

ABC Corporation, in the 35% tax bracket, receives $1,000,000 of stock dividend in 2006. If it had to pay tax on the entire $1,000,000, the tax would equal .35 × 1,000,000 = $350,000. But since it can take advantage of the DRD, where only 30% of that income is taxable, it only has to pay .35 × .30 × 1,000,000 = $105,000, a savings of $245,000. A nice tax break!

This tax advantage allows the issuer to pay a lower yield, saving it some money, even though the dividend payments are treated as a distribution of earnings for tax purposes, and is, therefore, not deductible for the issuer.

There is some preferred stock, issued before October 1, 1942, where the DRD is only 42%. These issues are referred to as old money, but almost all preferred stock today is new money, where the DRD is 30%. Partial money referred to a small set of issues that consisted of both old and new money.

Dividends

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Preferred stock is preferred because preferred shareholders have first claims to any dividends and to par value or some other stated value specified by the preferred stock contract, if liquidation occurs, over the common stockholder. However, creditors still get paid before preferred shareholders. The dividend for the common stock may fluctuate from year to year, or even from quarter to quarter, but the preferred dividend, or at least the dividend rate, is fixed by contract. Preferred stockholders get their dividend before any dividends are paid on common stock. However, dividends are not guaranteed even to preferred stockholders.

If payments are suspended for cumulative preferred stock, then the dividends in arrears may be paid later if the financial status of the company recovers, but it must be paid before any dividend is paid to common stockholders. The company must have earnings and the board of directors must declare a dividend before any liability for the payments is recognized. Thus, dividend in arrears is not recognized as a liability in its financial statements until a dividend is declared, but it should be listed in the company's financial statements. For noncumulative preferred stock, the payments are simply forfeited. The suspension of payments does not force a company into bankruptcy as the suspension of interest payments would.

Unlike common stock, the par value of preferred stock is more significant to the stockholder because the dividend rate is usually expressed as a percentage of the par value, which doesn't vary with the market price. If the stock has no par value, then the dividend will be stated as a fixed sum per share. Although almost all public preferreds issued before 1982 had a fixed dividend rate or a fixed dividend amount, most preferreds issued today have an adjustable dividend rate, usually pegged to some other interest rate, such as a particular class of U.S. Treasury.

Voting Rights

Preferred stockholders have contingent voting rights. They can only vote for some members of the board if the company defaults on the dividend for a specific number of quarters, or if the company wants to issue a new class of preferred stock equal to or better than the existing preferred stock. However, blank check preferred stock gives approved holders the right to vote as a means to thwart hostile takeover attempts.

Preferred Stock Types

A preferred stock is created by a preferred stock contract, written by the corporate issuer, so the corporation decides what the characteristics of the preferred stock will be. If the corporate issuer decides to provide characteristics that benefit itself, then it must compensate the investors by paying a higher dividend rate. Any characteristics of the preferred stock that benefit investors will allow the corporate issuer to pay a lower dividend rate. So in designing the preferred stock, the corporate issuer weighs the benefits and drawbacks of each characteristic. The most common characteristics of preferred stock — the priority of preferred stockholders over common stockholders both to dividend payments and to a return of their paid-in capital in the event of a corporate liquidation lowers the risk of the preferred stock over the common stock, thus, making it more appealing to investors.

Preferred stock can be characterized by how the dividend is set. If the dividend of a preferred stock is a percentage of par value, then it is referred to as a percentage preferred, so if a stock pays a 5% dividend, then it can be referred to as a 5% preferred. Note, however, that the par value is fixed, so the dividend is also fixed, regardless of the current market price of the preferred. If the preferred stock has no par value, then it pays a stated dollar amount, so if it pays a $5 dividend, it can be referred to as a $5 no-par preferred.

The following are the major types of preferred stock: perpetual, adjustable rate, cumulative, convertible, participating, and prior preferred.

Perpetual Preferred Stock (Perpetuity)

Perpetual preferred stock (aka perpetuity) has no specific maturity; hence the name. However, most are callable, which a company will do if interest rates drop below the yield of the preferred.

Adjustable Rate Preferred Stock

Most preferreds issued today have an adjustable dividend rate. An adjustable-rate preferred stock (ARPS) pays a dividend that is pegged, usually quarterly, to a current interest rate bellwether, such as a particular class of Treasury issues.

The dividend rate is reset quarterly, usually based on a spread from the greatest of 3 points in the Treasury yield curve, such as the 3-month, 10-year, and the 30-year Treasury rate. The predetermined spread is called the dividend reset spread, which is added or subtracted from the benchmark rate determined from the yield curve. Selecting 3 points in the Treasury yield curve offers some protection against shifts in the yield curve.

However, the interest rate usually has a collar, specified in the prospectus for the preferred stock—the interest rate will not rise above the upper collar, often called a cap or ceiling, nor fall below the lower collar, or floor. When the prevailing interest rates exceeds the limits of the collar, then the interest rate becomes fixed until the prevailing rates move back within the limits of the collar. When the interest rates are floating, the price of the preferred stock in the secondary market is not affected by prevailing interest rates; however, when rates exceed the collar, then the price of the preferreds will fluctuate with interest rates until the prevailing rates fall within the collar.

Cumulative Preferred Stock

If preferred stock has a cumulative dividend right, then any missed dividend payments to preferred shareholders must be paid before any payments to common stockholders. If the company liquidates, then the cumulative option gives preferred shareholders the right to all of the missed payments before any payments are issued from the common stockholders' residual interests.

Example: preferred stockholders of ABC Corporation get $40 per quarter for their preferred stock. The company has missed 3 quarterly payments in the past year, however. For the current quarter, the company would have to pay preferred stockholders $120 plus the $40 due this quarter before anything can be paid to common stockholders.

Convertible Preferred Stock

The convertible feature allows the shareholder to convert each share of preferred stock to a number of shares, specified in the preferred stock contract, of common stock at any time. Preferred stock is generally bought for its fixed dividend, but it is not as volatile as the common stock of the same company. If the common stock rises sharply, the convertible preferred stock will rise proportionately. Thus, the convertible feature allows the investor to enjoy a fixed income in a flat market, but also to profit from any significant rise in the market price of the common stock.

Another benefit of convertibility is that the holder may get increased dividends. If the company's earnings rise, and it pays a dividend on the common stock, then, if the preferred stock can be converted into more than 1 share of common stock, the total dividend received for the converted common shares may be greater than the preferred share.

In most cases, the investor decides when and if to convert; however, in some cases it can be forced if the company calls back the stock, or it may be specified, as in the case of Morgan Stanley's PERCS—Preferred Equity Redemption Cumulative Stock—which converts to common stock when it matures.

Preferred Equity Redemption Cumulative Stock (PERCS)

PERCS, developed by Morgan Stanley, pays a higher dividend than the issuer's common stock, has a specified maturity, usually about 3 years, and converts into common stock at maturity. It has a capital gains cap, usually 30%, and can be redeemed by the issuer at any time or when the common stock price reaches a specified level. However, to redeem PERCS before maturity, the issuer must pay a price that declines over the term of the PERCS, starting at the cap price plus all dividends that the PERCS holder is entitled to receive over the common stockholder down to the cap price shortly before maturation.

Participating Preferred Stock

This increasingly rare preferred stock not only receives its stated, fixed dividend, but it can also participate, or receive a portion, usually 50%, 75%, or 100%, of the common stock dividend.

Prior Preferred, First Claim Preferred, or Senior Preferred Stock

These terms describes the preferred stock that has first claims on any dividend, and on assets if the corporation dissolves. Thus, prior preferred stock will have a superior claim over all preferred and common stock, but will still have an inferior status to creditors, including all holders of debt securities.

Auction-Rate and Stated Rate Auction Preferred Stocks (STRAPS)

Although adjustable-rate preferred stocks (ARPS) were popular before the 2007-2009 credit crisis, some of them started to trade below par value because the credit quality of the issuing firm deteriorated, and thus, the dividend rate on the ARPS was not enough to compensate for the credit risk. In 1984, a new type of preferred—the auction-rate preferred stock—was created that reset the dividend rate every 28 or 49 days through a Dutch auction that consisted of current preferred stockholders and potential buyers of the stock, but limited by the interest rates on commercial paper. Stated rate auction preferred stocks (STRAPS) are similar, but the dividend rate is fixed for the first couple of years.

Remarketed Preferred Stock

The dividend rate of remarketed preferred stock is reset by a remarketing agent so that stockholders can sell their stock for par value. The investor has the choice of resetting the rate every 7 or 49 days. They often have a stipulated redemption date and are usually callable for par value.

Preferred Stock As an Investment

Generally, preferred stock has a higher income and less volatility than the common stock, and greater liquidity than bonds. Preferreds are often issued as a series, such as Series-A, Series-B, and so on. Preferred stock is bought for its dividend; therefore, preferred stock has more in common with bonds than it does with stock. Preferred stock that is not convertible into the common stock does not participate in any price rises of the common stock, since the preferred stockholder has no equity interest in the company. However, like bonds, the market prices of preferred stock vary with prevailing interest rates and with the credit rating of the issuer. Furthermore, preferred stock tends to rise in price as the ex-dividend date approaches, since the present value of the dividend increases. On the ex-dividend date, it drops in price because the present value of the next dividend is at its lowest value and because the payment of the next dividend is not assured, since the company must have earnings and the Board of Directors must declare a dividend before it is payable.

Since the dividend is the expected investment return, before buying a preferred stock, the investor should determine whether the company will be able to keep paying the dividend. A good indicator of this is the coverage ratio, which is earnings before interest and taxes (EBIT), divided by the sum of the company's total interest payments plus preferred stock dividends:

Coverage Ratio Formula
 Coverage Ratio =Earnings before Interest and Taxes
Interest Expense + Preferred Stock Dividends

A higher ratio indicates less risk, so the higher, the better. Some investors use EBITDA, earnings before interest, taxes, depreciation, and amortization. Depreciation and amortization are added because they are not annual expenses requiring a layout of cash. However, it is better to use EBIT, since most depreciable items eventually must be replaced.

Finally, preferred stock should be compared to other investments that pay a dividend or distribution. Many mutual funds, closed-end funds, or exchange-traded funds pay a dividend, especially those that are focused on income stocks. These funds are much more liquid than preferred stock, so they are easier to enter or exit. Other income-paying securities have other advantages. Real estate investment trusts (REITs), for instance, are required by law to distribute 90% of their income, so they pay a steady income that may actually increase over time, since real estate generally appreciates and rents can be raised to account for inflation. Hence, REITs, especially equity REITs, are not nearly as sensitive to interest rates as preferred stock. Master limited partnerships (MLPs) are also another type of investment that pays a substantial distribution, usually quarterly. A key advantage of MLP distributions is that a substantial portion, often around 80%, of the distribution is tax-deferred, until the MLP units are sold. Furthermore, both REITs and MLPs are an effective way to diversify a portfolio due to their lower correlation with stocks.