CHAPTER 15
Preferred Stock
Sarah Swammy
Preferred stock is a hybrid security with features common to both stocks and bonds. These securities are attractive to investors because they offer periodic income (fixed or variable payments), competitive returns (yields), liquidity (traded on major exchanges) and portfolio diversification. Preferreds are generally issued by companies that have outstanding common stock and normally issued with a par value of $25, which may correlate to the issuer's current market price and dividend. The main difference between common and preferred stocks is the manner in which dividends are paid. Common stock holders receive dividends only at the discretion of the issuer, based on the issuer's earnings and payout ratio. Preferred shareholders are entitled to receive dividends at a predetermined rate (either fixed or variable) by agreement. This agreement is similar to a bond indenture, and sets forth the respective rights and obligations of the preferred buyer and corporate issuer, but unlike most bonds, preferred shares do not have the same form of a guarantee to pay and thus are subordinate to bondholders. The dividends must be paid to preferred shareholders in full before any dividends can be paid to holders of common stock. In other words, payment of the preferred dividends is senior to the payment of dividends to common stockholders. The dividend is paid to preferred stockholders at a set rate as a percentage of par.
In addition, preferred stock investors have seniority over common stockholders in the event of a corporate liquidation (bankruptcy). In that event, preferred stockholders must be paid the full par value of their shares, plus any accumulated but unpaid dividends, before common stockholders receive anything.
Common Stock Features
- Ownership stake in company
- Greater potential for capital appreciation
- Typically has voting rights
Preferred Stock Features
- Ownership stake in company
- Likely to receive regular dividends
- Higher priority in event of bankruptcy
- Issued with a specified dividend rate
Several types of preferred stock will be examined in this chapter.
Although preferred stock is considered part of an issuer's equity base, it tends to trade more like debt. This is because the preferreds value is based primarily on its dividend yield, rather than a change in the underlying value of the business. The yield, expressed as an annual rate, can be compared to the coupon payment on a bond. The annual yield can be ascertained by dividing the annual dividend payment per share by its price per share. For example, let's assume that the current market interest rates for issuers rated “BAA” range from 5.75% to 6.25%; if the preferred stock of XYZ Corp. (which we will assume is rated BAA) has a par value of $25/share and pays an annual dividend of $1.50/share, it will have an annual yield of 6% 
). For this reason, preferred stock prices are very sensitive to changes in prevailing interest rates. In a rising interest rate environment, the market yields on preferred issues will also rise. Accordingly, holders of preferred stock that offers a below‐market yield will experience a decline in market value. The amount of the decline will be based in large part on the dividend yield and term of the security in addition to any change in the creditworthiness of the issuer.
PERPETUAL PREFERRED STOCK
Traditional perpetual preferred issues, unlike bonds, do not have a maturity date. Unlike a bond, there is no guarantee that the investment will ever be redeemed at par. As a result, perpetual preferred issues can be more volatile and riskier than the longest maturity bond. The perpetual preferred issuance is booked as equity on an issuer's balance sheet. Preferred stocks generally are issued at par values of $25, $50, or $100. However, today most issues are priced at $25. Financial services issues, including banks and REITs, have accounted for the largest percentage of issuance over the past 20 years, followed by utilities and, to a far lesser extent, industrials. Banks have particularly utilized preferreds due to preferential regulatory capital treatment where it may count preferred issues as Tier‐1 capital.
There are two types of perpetual preferred stock, fixed and floating rate. Fixed‐rate preferred stocks carry a fixed dividend that can be stated in dollar terms or as a percentage of the par value of the security. Floating‐rate preferred stocks pay dividends that vary with short‐term interest rates.1
DIVIDEND‐RECEIVED DEDUCTION (DRD)
An important characteristic of the perpetual preferred market is that most of these issues qualify for a 70% tax exclusion on their dividends. This is known as the dividend‐received deduction (DRD) and is designed to avoid multiple taxation of dividends paid from one corporation to another. To be eligible, you must be a U.S. corporation that receives a dividend from another U.S. corporation, or U.S.‐based subsidiary of a foreign corporation that is already subject to U.S. income tax. Eligible corporations are entitled to exclude 70% of preferred stock dividends from gross income. A preferred issue with a 6% yield, for example, would only have 30% of the cash dividend subject to tax. If you assume a corporate tax rate of 35% on the taxable part of the payout, the corporate holder would retain 89.5% of the yield after‐tax, instead of 65% (as in the case of a fully taxable investment). The following formula can be used to calculate the equivalent yield that would be necessary on a fully taxable security (to corporate investors assuming a 35% tax rate) to provide the same after‐tax return as a preferred with the DRD exclusion for any given dividend rate:
Assuming a dividend rate of 6%, the taxable equivalent rate would be 8.26%. An eligible corporate account would need a return that exceeded 8.26% to best a DRD preferred paying 6%, on an after‐tax basis. Table 15.1 exemplifies the taxable equivalent yield of various coupon levels containing the DRD exclusion.
Table 15.1: Taxable Equivalent Yields with Dividend‐Received Deduction
| Preferred Coupon | After‐Tax Return | Taxable Equivalent Yield |
| 5.00% | 4.48% | 6.89% |
| 6.00% | 5.37% | 8.26% |
| 7.00% | 6.27% | 9.64% |
The standard formula for calculating the effective taxable yield of a DRD preferred regardless of coupon or tax rate is:
where
| D | = | dividend rate |
| T | = | tax rate |
Here's a shortcut formula for converting DRD yields to taxable and tax‐exempt adjusted yields:
- To convert to Taxable Equivalent → multiply DRD rate × 1.377
- To convert to Tax‐Exempt Equivalent → multiply DRD rate × .895
Another factor to note is that the security must be held for at least 46 days in order to receive the tax exclusion. As a result of the tax ramifications to the corporate investor, DRD issues generally carry lower dividend rates than other types of preferreds. It should be noted that subchapter S corporations are ineligible to take the DRD exclusion.
The 70% exclusion can be taken only on qualified perpetual preferreds issued after October 1, 1942. These issues are referred to as “new‐money” preferreds. A number of utility preferreds issued prior to that date are known as “old‐money” preferreds and do carry a DRD exclusion but only approximately 42%. The Internal Revenue Code provides a formula that takes the current tax rate level into account in calculating old‐money DRD. At that time, the issuing utilities had already deducted a portion of the dividend on their own returns as an expense. Old‐money issues that are refunded, or refinanced, remain at the reduced exclusion rate.
FIXED TO FLOAT
Another group of preferred issues are called adjustable‐ or floating‐rate preferreds. These issues carry dividend rates that can reset quarterly at a spread to one or more benchmark government markets or to the London Interbank Offered Rate (LIBOR). In addition, many of these issues have maximum and minimum coupon limits that they can pay. There is no guarantee that these floaters will remain at par (issue price) as the coupon changes to reflect the interest rate environment at any point in time. For example, a floater with a maximum cap of 8% would probably fall in price if general market rates exceeded 8%.
NONCUMULATIVE PREFERRED STOCK
Many issues of preferred stock are noncumulative with respect to dividends. If the dividend is noncumulative, the issuer is under no obligation to pay any arrearages in the future. Not all preferred stock is noncumulative.
CUMULATIVE PREFERRED STOCK
A cumulative preferred stock is a type of preferred stock with a provision that stipulates that if a preferred dividend is not paid when due, it accumulates and must be paid in full before the company distributes dividends to common stockholders.
For risk‐averse investors, purchases in noncumulative preferreds should be limited to higher‐rated issues.
CONVERTIBLE PREFERRED STOCK
Convertible preferred shares are corporate fixed‐income securities in which an investor has an option to convert its shares into a prescribed number of shares of the issuer's common stock after a predetermined date or on a specific date at a prescribed price per share. The conversion option allows the holder to participate in the upward movement of the underlying common stock. Many convertibles have a specific period in which they can be converted. The following example will help clarify some of the terms relating to convertibles:
- XYZ 6.00% convertible preferred priced at an initial public offering of $50 per share
- Convertible any time into 4.8605 shares of XYZ common
- Conversion price of $10.287
- Current price of common: $13.40
- Current price of preferred: $72.74
The conversion ratio is the number of common shares that the convertible holder would receive.
Parity exists when the price of the convertible preferred is equivalent (when exchanged) to the current price of the common stock as depicted here:
In this example, with the convertible issue currently priced at $72.34, the common stock price would have to be $14.96 to achieve parity.
If the market conversion price ($14.96) is greater than the actual common stock price ($13.40), the convertible is selling at a conversion premium. The conversion premium ratio is the percentage increase needed to reach parity. In this case it would be:
If the convertible preferred is selling above parity, it is valued at a premium. Convertible preferreds usually trade at a premium over parity as buyers are willing to bid up the higher‐yielding instrument with the expectation of realizing some of the potential upside performance in the price of the common stock.
Another factor that should be noted is that the issuer may be able to force the conversion at some point in time, depending on where the price of the common is trading. In addition, the conversion price may be subject to adjustments upon certain events. It is important to examine the final prospectus in order to avoid any surprises.
There are also mandatory convertible securities that differ from those discussed above in that they require the purchase of a variable number of shares of the common stock of the issuer by the preferred holder on or before a specified date. This is done regardless of where the common stock is trading and, as a result, investors bear the risk of losing part of their original investment.
FEATURES OF PREFERRED STOCK
Call Features
Although traditional preferred stocks generally do not have a specified maturity date, most issues include a provision that gives the issuer an option to redeem shares periodically. These provisions are usually exercised in a declining rate environment when it is cost‐effective for an issuer to call in higher dividend paying stock. While in theory perpetual preferred stock has unlimited term, most are redeemable after a set period of time, for example, 5 years, 10 years, and so forth. Most issues have call protection for five years, meaning that the issuer may not call the issue for five years. Preferred stock is usually called at par value, and some call provisions may include a premium over par. Investors who purchase preferred stock at a premium to par or the stated value should be fully aware of call features that could sharply reduce the effective return or could even generate a negative return.
The prorated yearly loss is then subtracted from the annual dividend or payout in order to properly calculate the true return on investment of the security. The following formula can be used to calculate the yield to call:
- Given a $25 par preferred issue with a 6.125% coupon, or $1.53 dividend rate with a call at par 4 years and trading at $26.625, the yield to call would be 4.52%, not the 6.125% dividend rate.
Voting Rights
Generally, preferred shareholders do not have voting rights unless preferred dividends have been in arrears for a specified period of time, generally six quarterly payments. At that point, nonvoting preferred shareholders may elect some number of directors (at least two) to the company's board of directors. Voting rights are continuous until the cumulative dividends have been paid in full. Once any arrearage has been paid, the preferred shareholders are no longer eligible to vote. In the case of noncumulative dividends, voting rights would end after the regular quarterly dividend has been paid for a year.
Sinking Funds
A preferred issue may include provisions for a sinking fund. This provision requires the issuer to retire a certain percentage of the total issue over a specified period of time. Eventually, the entire issue will be retired during the time period prescribed. It should be noted that issues with sinking funds can also carry other call options for the issuer. Issuers can meet the sinking‐fund requirement by calling the required number of shares on the sinking fund payment date or by purchasing shares in the open market. The primary difference between call features and sinking funds is that with a standard call feature, the issuer may call its issues on a voluntary basis while a sinking fund is mandatory and must conform to a set schedule as described in the prospectus.
Foreign Issuers
In 2003, new federal legislation reduced taxes on dividend income and capital gains on certain preferred securities held more than 60 days. The new tax rates consist of a 5% tax on lower income brackets and a 15% tax on the higher brackets. This favored tax treatment applies only to the types of domestic issues discussed earlier (perpetual, sinking fund, and convertible preferreds). There are also some foreign ADR issues that would qualify. An American Depositary Receipt (ADR) is a receipt issued by a U.S. depositary bank that represents shares of a foreign corporation held by the depositary bank. ADR issues trade in dollars and in a manner similar to domestic issues. To qualify for this favored tax treatment, a foreign issuer would have to be incorporated in a possession of the United States or be party to a comprehensive income tax treaty with the United States. The preferred stock must be perpetual, trade in the U.S. markets, and have all its dividends paid out of earnings. Qualified dividends do not include those paid by foreign entities that are either a foreign investment company, a passive foreign investment company, or a foreign personal holding company.
In addition, the tax‐advantaged rates do not apply to dividends received in tax‐deferred retirement accounts. Non‐U.S. preferred securities now account for a significant part of the market and are usually issued by highly rated financial institutions. They are generally initially priced at $25 and listed on U.S. equity exchanges. Since the securities are priced in dollars, they do not possess currency risk. Historically, foreign issues have offered higher yields than equivalently rated domestic issues. Examples of some of the foreign issuers who regularly offer these securities include: ING, Royal Bank of Scotland, Abbey National, and ABN AMRO. There are several types of non‐U.S. securities to choose from under the preferred umbrella, including perpetual $25 par stock, baby bonds, perpetual trust preferred securities, and exchangeable capital securities.
ANTICIPATING THE RISKS
Call Risk
As discussed earlier, most preferred stocks contain call provisions. This option benefits issuers, since they have the right to exercise the call option at a time of their choosing. Generally, this will be during a period of declining interest rates, when you (the investor) will be hard‐pressed to find a replacement investment of similar quality offering as high a dividend. Since many preferreds contain only a five‐year non‐call period, the price appreciation of these securities will be limited when compared to traditional long‐term non‐callable bonds. While preferreds can appreciate, the potential upside is potentially limited by the issuer's call option. Since the securities can be called away by the issuer at the expiration of the non‐call period, the security will not appreciate far above the call price as that date approaches, regardless of the price appreciation occurring in the general market.
Credit Risk
As with all corporate instruments, there is always a risk that the issuer will default on its obligations. While preferred stockholders have seniority with respect to dividends and assets over common stockholders, their rights are subordinate to bondholders and other general creditors of the corporation. As a result, it is imperative that an investor assess the creditworthiness and financial standing of the corporate issuer. Many investors undertake careful review of individual companies to determine their ability to make timely dividend payments. Most, however, rely largely on the publish ratings from the three major national credit rating organizations (Moody's, Standard & Poor's, and Fitch). Historically, these agencies' independent credit ratings have been utilized by most investors as an important factor when evaluating the credit quality of the securities they are considering. In the aftermath of the financial crisis of 2008–2009, investors have taken a more critical eye on the evaluations from these large ratings organizations. Their views remain an important data point for investors, but there is additional competition from other ratings firms, as well as heightened individual analysis on specific issuers. Investors should perform their own credit and structure analysis before making any investment decision.
Liquidity Risk
Liquidity risk deals with the following question: How quickly can an issue be sold for a price that closely approximates its fair market value? The easiest way to evaluate the liquidity of an issue is to look at the spread between the quoted bid and offer prices. Market makers play an important role in the liquidity of any particular preferred stock. The hybrid nature of a preferred contributes to its liquidity profile. A preferred security trades like an equity on exchange; however, the transparency of liquidity is similar to that of a traditional bond. The bond market is primarily a dealer‐to‐dealer market where dealers contact each other to find the best price available for a security. Market makers in preferred securities can operate in this same manner to find liquidity within the spread of any particular security. In many cases market makers are willing to buy and sell preferred securities within the quoted spread of a certain issue without advertising or “showing” those positions. Liquidity is based on a number of factors, including the size of the issue, whether it is listed on an exchange, and the particular features of the security, to name a few. Of course, during periods of adverse news (a credit downgrade, for instance) liquidity may temporarily dry up and the security will not trade until a new market level is established. But for buy‐and‐hold investors, liquidity is not as significant an issue.
Interest Rate Risk
Since preferred stock is essentially a fixed‐income security, frequently with a long duration, its price will normally fall with any increase in market interest rates. Furthermore, as mentioned earlier, the conventional five‐year call limits the potential for upward price appreciation in a period of falling interest rates. This negative convexity poses potential concern for the preferred investor; the issue may significantly underperform other types of fixed‐income securities in a changing interest rate environment. For example, in a period of rising interest rates, the preferred's long duration will cause it to fall in price more quickly than other shorter‐duration instruments. This risk may be mitigated to some degree by the relatively high dividend payment.
PREFERRED STOCK ISSUANCE AND TRADING
The secondary market is where owners of outstanding securities may either buy or sell their preferred stock. The primary market is where broker‐dealers initially sell securities to investors on behalf of the issuing corporation. Once sold in the primary market, these securities are now traded by investors in the secondary market. The secondary market includes securities that trade on exchanges, such as the New York Stock Exchange (NYSE). In addition, many issues trade over‐the‐counter (OTC) through a network of dealers who buy and sell the securities that are not exchange‐listed. Most OTC securities are traded through the NASDAQ system.
Preferreds can generally be identified in stock tables by a series that is differentiated by letters in the alphabet—for example, series A, B, C, and so forth. When you're checking the stock listings, a preferred stock might have the company ticker symbol followed by an underscore and the letter P (or Pr), denoting that the stock is preferred rather than common. This is followed by the appropriate letter series signifying the specific issue.
CONCLUSION
Preferred stocks are similar to bonds in that there is a fixed or variable payment to the holder backed by the earning power and cash flow of the issuing corporation. There are a number of factors that can affect the price of a preferred, including the direction of interest rates, the creditworthiness of the issuer, the structural features and tax implications of an individual issue, and the liquidity of a given issue. Corporations are large buyers of perpetual domestic issues due to the favorable tax treatment of the dividends. They can realize after‐tax yields significantly higher than fully taxable investments.
While preferred stocks have historically been purchased primarily by institutions, the emergence of the $25 par security changed the landscape dramatically. The $25 per‐share price comes in a variety of forms and requires less of an investment commitment for the individual investor. Combine this retail‐friendly issuance denomination with the price transparency for exchanged‐traded issues (most larger, well‐capitalized issuers have their preferred stock listed), relatively low transaction costs, favorable tax treatment on many forms of issuance, and high dividend yields, and we have a fixed‐income product well‐suited to the retail fixed‐income investor.