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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.
Although it is listed as equity in financial statements, preferred stock—unlike common stock—does not give the holder an ownership interest in the company, which is why preferred stockholders do not have the right to vote for the board of directors except under special circumstances.
Preferred stock is a hybrid security that shares characteristics of both bonds and stocks. Preferred stocks differs from bonds in the following ways:
The dividend, which refers to the payments that are equivalent to interest payments, is paid quarterly instead of semi-annually.
Preferred stock is issued in smaller denominations—usually $25-$100, although some issues can have much larger denominations.
Dividend payments can be suspended when the company is distressed.
Because dividends are a distribution of a company's earnings—not interest—they have different tax characteristics.
Most preferreds have no stated maturity; thus, they are sometimes referred to as a perpetuity.
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 it doesn't obligate a company to future payments in the way that bonds do.
Preferred stock is much like common stock, but preferred stockholders usually have no voting privileges, but they do have priority for dividends and for the proceeds of any corporate liquidation should the company fail. 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 more, and may also include 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.
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.
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.
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 x 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 x .30 x 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.
Preferred stock is preferred because preferred shareholders have first claims to any dividends and company assets, 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, that is usually pegged to some other interest rate, such as a particular class of U.S. Treasury.
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 is issued with varying qualities: perpetual, adjustable rate, cumulative, convertible, callable, participating, and prior preferred.
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.
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. However, the interest rate usually has a collar, which is 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.
If preferred stock has a cumulative dividend right, then, if the company misses any payment of dividends to preferred shareholders, all dividends of all missed payments must be paid before any common stockholder. If the company liquidates, then the cumulative option gives preferred shareholders the right to all of the missed payments before 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.
The convertible feature allows the shareholder to convert each share of his 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 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 becomes converted to common stock when it matures.
This feature benefits the company. It allows the company to call back, or to redeem, a callable preferred stock at a specific price, the call price, which is 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.
However, if the stock is called, then the stockholder must receive the par value of the stock, the call premium, any dividends in arrears, and the last dividend prorated from the last dividend date to the call date.
The main reasons that a company may call back its preferred shares is to force the conversion to common shares that pay a lower dividend; or to issue preferred stock or debt with a lower interest rate, or simply to retire the issue to stop making dividend payments.
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, which starts 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.
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 stocks’ dividend.
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.
Although adjustable-rate preferred stocks are popular, 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.
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.
Fixed rate capital securities (aka hybrids) are like preferred stock, but with a few peculiarities. There is no DRD tax advantage; thus, they pay a higher yield than preferred stocks or bonds from the same issuer. The have a lien status that is higher than preferreds but below creditors, and they carry the credit rating of the issuer. They are traded in the OTC market and most are also listed on the NYSE and AMEX stock exchanges. Most are priced at $25 per share, they have a stated maturity, and are callable after 5 to 10 years. Most issuers are utilities, industrial companies, and financial institutions.
FRCS are also classified based on how they are issued:
Specific FRCS are known by acronyms and names which describe the frequency of the payments, or how they are issued, such as:
The main difference between preferreds and FRCS is that FRCS pay interest—not dividends—monthly, quarterly, or semi-annually, but can be deferred if the company is in financial trouble. However, payments can be deferred only if no dividends are being paid for the issuer's common or preferred stock, and if the interest payments are deferred, then interest continues to accumulate until it is paid. Sometimes FRCS are issued as zero coupon bonds, which are original issue discount (OID) instruments.
However, these securities can have tax complications, either because of interest payment deferral or because they are OIDs. In these cases, interest accrues, and if it is not paid in the year earned, then the investor in these securities must pay taxes on the accrued interest, which is calculated according to complex laws and formulas. For more info, see Guide to Original Issue Discount (OID) Instruments, Publication 1212.
Besides the deferral risk mentioned above, there is also a special event risk, which allows the issuer to redeem the FRCS, at any time, for face value, if the tax law changes that disallows the tax deduction for the interest payments for the issuer's parent company.
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