2.3 Preferred Stock

Preferred stock sits between common stock and bonds in the investment hierarchy. It offers features of both equity and debt, making it a unique security that appears frequently on the SIE exam. Understanding the characteristics, types, and tradeoffs of preferred stock is essential.

What Is Preferred Stock?

Preferred stock is an equity security that typically pays a fixed dividend and has priority over common stock for dividends and liquidation proceeds. Despite the name, preferred stockholders usually do not have voting rights.

Think of preferred stock as a "hybrid" security:

- Like bonds: Fixed dividend payments, priority claims

- Like stocks: Ownership stake, no maturity date, dividends (not interest)

Common Stock vs. Preferred Stock

Voting rights: Common Stock - Yes; Preferred Stock - Usually no

Dividend amount: Common Stock - Variable; Preferred Stock - Fixed

Dividend priority: Common Stock - Paid second; Preferred Stock - Paid first

Liquidation priority: Common Stock - Last; Preferred Stock - After bondholders, before common

Growth potential: Common Stock - Unlimited; Preferred Stock - Limited

Price volatility: Common Stock - Higher; Preferred Stock - Lower

Key Characteristics of Preferred Stock

Fixed Dividend Rate

Preferred stock dividends are stated as either:

- Dollar amount: "$4.00 preferred" pays $4.00 per year

- Percentage of par: "5% preferred" with $100 par pays $5.00 per year

Annual Dividend = Par Value times Stated Rate

Example: 6% preferred, $100 par = $100 x 0.06 = $6.00 annual dividend

Par Value Matters

Unlike common stock, par value is meaningful for preferred stock. It determines:

- The dividend amount (if stated as a percentage)

- The call price (if callable)

- The liquidation preference

Most preferred stock has a par value of $25 or $100.

No Voting Rights

Preferred stockholders typically cannot vote on corporate matters. They sacrifice voting rights in exchange for dividend priority and fixed payments.

Priority in Liquidation

If a company is liquidated, the payment order is:

1. Secured creditors (bondholders with collateral)

2. Unsecured creditors

3. Preferred stockholders - Priority over common

4. Common stockholders

Types of Preferred Stock

Cumulative Preferred

Cumulative preferred stock accumulates unpaid dividends that must be paid before any common stock dividends.

Example: A company skips its $4 preferred dividend for 2 years. Before paying any common dividends, it must pay preferred shareholders $12 (3 years of $4 dividends: 2 skipped years plus current year).

Dividends in arrears are the accumulated unpaid dividends on cumulative preferred stock.

Non-Cumulative Preferred

Non-cumulative preferred stock does not accumulate unpaid dividends. If the company skips a dividend, shareholders lose that payment forever.

Key Point: If a preferred stock type is not specified, assume it is cumulative. Most preferred stock is cumulative.

Participating Preferred

Participating preferred stock can receive additional dividends beyond the stated rate if the company performs exceptionally well.

- Receives its fixed dividend first

- Then may participate in additional dividends with common stockholders

- Relatively rare in practice

Convertible Preferred

Convertible preferred stock can be exchanged for a specified number of common shares at the holder's option.

Conversion ratio: Number of common shares received per preferred share

Conversion price: Effective price paid per common share upon conversion

Parity price: Market price where preferred equals converted common value

Conversion Formula:

Parity Price = Preferred Market Price divided by Conversion Ratio

Example: Convertible preferred with conversion ratio of 4:1 trades at $120. Parity price = $120 / 4 = $30. If common stock exceeds $30, conversion becomes attractive.

Callable Preferred

Callable preferred stock can be redeemed by the issuer at a specified price (usually par plus a premium) after a certain date.

Companies typically call preferred stock when interest rates fall. They can issue new preferred at a lower rate and retire the higher-rate shares.

Investor Risk: When preferred is called, investors lose their income stream and must reinvest at potentially lower rates.

Adjustable-Rate Preferred

Adjustable-rate preferred stock has a dividend rate that fluctuates with a benchmark interest rate (such as Treasury rates).

- Dividend adjusts periodically (quarterly, annually)

- Provides some protection against interest rate changes

- Price tends to be more stable than fixed-rate preferred

Preferred Stock Risks

Interest Rate Risk

Preferred stock prices move inversely to interest rates:

- When interest rates rise, preferred prices fall

- When interest rates fall, preferred prices rise

This relationship exists because preferred stock competes with bonds for income-seeking investors.

Call Risk

If the preferred stock is callable, the company may redeem shares when it benefits the issuer (usually when rates have fallen), leaving investors to reinvest at lower rates.

Dividend Risk

While preferred dividends have priority over common, they are not guaranteed. If a company experiences financial difficulty, it can suspend preferred dividends (though cumulative dividends would accumulate).

Limited Upside

Unlike common stock, preferred stock typically does not participate in company growth. The price tends to trade around par value, limiting capital appreciation potential.

Preferred Stock vs. Bonds

Payment type: Preferred Stock - Dividends (from after-tax income); Bonds - Interest (tax-deductible for issuer)

Payment obligation: Preferred Stock - Not legally obligated; Bonds - Legally obligated

Maturity: Preferred Stock - Perpetual (no maturity); Bonds - Fixed maturity date

Bankruptcy priority: Preferred Stock - Below bondholders; Bonds - Above preferred stock

Tax treatment for issuer: Preferred Stock - Not deductible; Bonds - Interest is deductible

Tax treatment for investor: Preferred Stock - May qualify for dividend tax rates; Bonds - Taxed as ordinary income

Key Takeaways

- Preferred stock pays fixed dividends and has priority over common stock

- Cumulative preferred accumulates unpaid dividends

- Convertible preferred can be exchanged for common shares

- Callable preferred can be redeemed by the issuer

- Preferred stock prices move inversely with interest rates

- Preferred shareholders typically have no voting rights