5.2 Preferred Stock

Preferred stock is a hybrid security that combines characteristics of both equity and debt. It offers fixed dividends and priority over common stock, but typically lacks voting rights. Understanding the various types of preferred stock is essential for the Series 65 exam.

Characteristics of Preferred Stock

Preferred stock sits between bonds and common stock in terms of risk and return.

Preferred Stock: Income, fixed dividends; Payment Priority, after bonds, before common; Voting Rights, usually none; Maturity, usually perpetual; Tax Treatment (Issuer), not deductible; Tax Treatment (Investor), qualified dividend rates

Common Stock: Income, variable dividends; Payment Priority, last; Voting Rights, yes; Maturity, perpetual; Tax Treatment (Issuer), not deductible; Tax Treatment (Investor), qualified dividend rates

Bonds: Income, interest payments; Payment Priority, first; Voting Rights, none; Maturity, fixed date; Tax Treatment (Issuer), interest is deductible; Tax Treatment (Investor), ordinary income

Fixed Dividend Rate

Preferred dividends are stated as either:

- Dollar amount: "$4 preferred" pays $4 per share annually

- Percentage of par: "6% preferred" with $100 par pays $6 annually

In Practice

A "6% cumulative convertible preferred stock" with $100 par value tells you:

- Dividend = $100 x 6% = $6 per year

- Missed dividends accumulate (cumulative)

- Can be converted to common stock (convertible)

Types of Preferred Stock

Cumulative Preferred Stock

Cumulative preferred is the most investor-friendly type. If the company misses any dividend payments, those unpaid dividends accumulate as dividends in arrears. ALL arrears must be paid before any dividends can be paid to common stockholders.

Example:

- Company misses dividends for 2 years on $100 par, 5% cumulative preferred

- Arrears = $5 x 2 years = $10 per share

- Before paying common dividends, company must pay: $10 arrears + current $5 = $15 per share

Non-Cumulative Preferred Stock

With non-cumulative preferred, missed dividends are simply forfeited, they do not accumulate. This is riskier for investors, so non-cumulative preferred typically offers higher dividend rates to compensate.

On the Exam

Most preferred stock is cumulative. If a question doesn't specify, assume cumulative. Questions often test whether arrears must be paid before common dividends (yes, for cumulative preferred).

Convertible Preferred Stock

Convertible preferred gives holders the option to exchange their preferred shares for a fixed number of common shares. This provides upside potential if the common stock appreciates.

Key Concepts

Conversion Ratio: Number of common shares received; Fixed at issuance

Conversion Price: Effective price paid for common; Par Value divided by Conversion Ratio

Conversion Value: Market value if converted; Common Price x Conversion Ratio

Conversion Premium: Amount preferred trades above conversion value; (Preferred Price - Conversion Value) divided by Conversion Value

Example

A $100 par convertible preferred can be converted into 4 shares of common stock:

- Conversion ratio = 4

- Conversion price = $100 / 4 = $25

- If common trades at $30: Conversion value = 4 x $30 = $120

- The preferred would trade at or above $120

Trade-off

Convertible preferred typically pays a lower dividend than non-convertible preferred because the conversion option has value. Investors accept less income for the potential capital appreciation.

Callable Preferred Stock

Callable preferred gives the issuer the right to redeem (call back) the shares at a predetermined price after a specified date.

Key Features

- Call price: Usually at a small premium to par (e.g., $105 for $100 par)

- Call protection period: Time during which shares cannot be called

- Call date: Earliest date issuer can call the shares

Why Issuers Call Preferred Stock

Issuers typically call preferred stock when interest rates decline. If a company issued 7% preferred when rates were high, and rates drop to 4%, the company can:

1. Call the existing 7% preferred

2. Issue new preferred at 4%

3. Save 3% annually on dividend payments

Investor Risk

Callable preferred limits investor upside. If interest rates fall:

- Preferred price would normally rise

- But the call feature caps the price near the call price

- Investors face reinvestment risk, proceeds must be reinvested at lower rates

Participating Preferred Stock

Participating preferred allows shareholders to receive additional dividends beyond the stated rate if the company is exceptionally profitable.

Types of Participation

- Partially participating: Additional dividends up to a cap

- Fully participating: Share proportionally in all excess profits

Example

A fully participating preferred with a 5% stated dividend might:

1. Receive its 5% dividend first

2. Wait for common to receive its dividend

3. Then share in any additional distributions alongside common

Participating preferred is relatively rare but appears on exams.

Adjustable-Rate Preferred Stock

Adjustable-rate preferred (also called floating-rate or variable-rate preferred) has a dividend rate that adjusts periodically based on a benchmark interest rate.

Common Benchmarks

- Treasury bill rates

- LIBOR (historically) / SOFR (currently)

- Prime rate

Benefits

Price stability: Rate adjustments keep price near par

Reduced interest rate risk: Dividend increases when rates rise

Attractive in rising rate environments: Dividend keeps pace with market rates

Trade-off

Adjustable-rate preferred typically offers a lower initial yield than fixed-rate preferred because the rate-adjustment feature reduces risk.

Preferred Stock in Liquidation

In a corporate liquidation, claims are paid in this order:

1: Secured creditors (collateralized loans)

2: Unsecured creditors (general bonds, trade creditors)

3: Subordinated debt holders

4: Preferred stockholders

5: Common stockholders

Preferred stockholders have priority over common but are subordinate to all debt.

Preferred Stock vs. Bonds: Tax Comparison

For corporate investors, preferred stock dividends have a significant tax advantage:

Dividends-Received Deduction (DRD)

Corporations that receive dividends from other corporations can exclude a portion from taxable income:

- 50% exclusion if owning less than 20% of stock

- 65% exclusion if owning 20-80%

- 100% exclusion if owning 80%+ (affiliated companies)

This makes preferred stock attractive for corporate treasury investments.

Key Takeaways

- Preferred stock is a hybrid security with characteristics of both stocks and bonds

- Cumulative preferred protects investors, missed dividends accumulate as arrears

- Convertible preferred offers upside potential but pays lower dividends

- Callable preferred benefits issuers, they call when rates decline

- Adjustable-rate preferred offers price stability through rate adjustments

- Preferred stockholders are ahead of common but behind all debt in liquidation

- The dividends-received deduction makes preferred attractive for corporate investors