Preferred stock


Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.
Like bonds, preferred stocks are rated by major credit rating agencies. Their ratings are generally lower than those of bonds, because preferred dividends do not carry the same guarantees as interest payments from bonds, and because preferred-stock holders' claims are junior to those of all creditors.
Preferred equity has characteristics similar to preferred stock, but the term is typically used for investments in real estate or other private investments where the common stock is not publicly traded, so private equity has no public credit rating.

Features

Features usually associated with preferred stock include:
  • Preference in dividends
  • Preference in assets, in the event of liquidation
  • Convertibility to common stock
  • Callability at the corporation's option
  • Nonvoting
  • Higher dividend yields

    Preference in dividends

In general, preferred stock has preference in dividend payments. The preference does not assure the payment of dividends, but the company must pay the stated dividends on preferred stock before or at the same time as any dividends on common stock.
Preferred stock can be cumulative or noncumulative. A cumulative preferred requires that if a company fails to pay a dividend, it must make up for it at a later time in order to ever pay common-stock dividends again. Dividends accumulate with each passed dividend period. When a dividend is not paid in time, it has "passed"; all passed dividends on a cumulative stock make up a dividend in arrears. A stock without this feature is known as a noncumulative, or straight, preferred stock; any dividends passed are lost if not declared.

Other features or rights

  • Preferred stock may or may not have a fixed liquidation value associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued.
  • Preferred stock has a claim on liquidation proceeds of a stock corporation equal to its par value, unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.
  • Almost all preferred shares have a negotiated, fixed-dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating; they may change according to a benchmark interest-rate index.
  • Some preferred shares have special voting rights to approve extraordinary events or to elect directors, but most preferred shares have no voting rights associated with them; some preferred shares gain voting rights when the preferred dividends are in arrears for a substantial time. This is all variable on the rights assigned to the preferred shares at the time of incorporation.
The above list is not comprehensive; preferred shares may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision, enabling the issuing corporation to repurchase the share at its discretion.

Types

In addition to straight preferred stock, there is diversity in the preferred stock market. Additional types of preferred stock include:
  • Prior preferred stock—Many companies have different issues of preferred stock outstanding at one time; one issue is usually designated highest-priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the payments on the prior preferred. Therefore, prior preferreds have less credit risk than other preferred stocks.
  • Preference preferred stock—Ranked behind a company's prior preferred stock are its preference preferred issues. These issues receive preference over all other classes of the company's preferred. If the company issues more than one issue of preference preferred, the issues are ranked by seniority. One issue is designated first preference, the next-senior issue is the second and so on.
  • Convertible preferred stock—These are preferred issues that holders can exchange for a predetermined number of the company's common-stock shares. This exchange may occur at any time the investor chooses, regardless of the market price of the common stock. It is a one-way deal; one cannot convert the common stock back to preferred stock.
  • Cumulative preferred stock—If the dividend is not paid, it will accumulate for future payment.
  • Non-cumulative preferred stock—Dividends for this type of preferred stock will not accumulate if they are unpaid; very common in TRuPS and bank preferred stock, since under BIS rules preferred stock must be non-cumulative if it is to be included in Tier 1 capital.
  • Exchangeable preferred stock—This type of preferred stock carries an embedded option to be exchanged for some other security.
  • Participating preferred stock—These preferred issues offer holders the opportunity to receive extra dividends if the company achieves predetermined financial goals. Investors who purchased these stocks receive their regular dividend regardless of company performance. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.
  • Perpetual preferred stock—This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder ; most preferred stock is issued without a redemption date.
  • Putable preferred stock—These issues have a "put" privilege, whereby the holder may force the issuer to redeem shares.
  • Monthly income preferred stock—A combination of preferred stock and subordinated debt.

    Usage

Preferred stocks offer a company an alternative form of financing—for example through pension led funding; in some cases, a company can defer dividends by going into arrears with a little penalty or risk to its credit rating, however, such action could hurt the company meeting the terms of its financing contract. With traditional debt, payments are required; a missed payment would put the company in default.
Occasionally, companies use preferred shares as a means of preventing hostile takeovers, creating preferred shares with a poison pill that is exercised upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as a takeover defence; they may be assigned very high liquidation value, or may have great super-voting powers.
When a corporation goes bankrupt, there may be enough money to repay holders of preferred issues known as "senior" but not enough money for "junior" issues. Therefore, when preferred shares are first issued, their governing document may contain protective provisions preventing the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu, or junior relationship with other series issued by the same corporation.

Users

Preferred shares are more common in private or pre-public companies, where it is useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may either encourage or discourage the issuance of publicly traded preferred shares. In many countries, banks are encouraged to issue preferred stock as a source of Tier 1 capital.
A company may issue several classes of preferred stock. A company raising venture capital or other funding may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock. Such a company might have "Series A Preferred", "Series B Preferred", "Series C Preferred", and corresponding shares of common stock. Typically, company founders and employees receive common stock, while venture capital investors receive preferred shares, often with a liquidation preference. The preferred shares are typically converted to common shares with the completion of an initial public offering or acquisition. An additional advantage of issuing preferred shares to investors but common shares to employees is the ability to retain a lower 409 valuation for common shares and thus a lower strike price for incentive stock options. This allows employees to receive more gains on their stock.
In the United States, there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity and pay a stipulated dividend rate to the holder. Convertible preferreds—in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company under certain conditions.
There are income-tax advantages generally available to corporations investing in preferred stocks in the United States. See Dividends received deduction.
But for individuals, a straight preferred stock, a hybrid between a bond and a stock, bears some disadvantages of each type of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in future earnings and dividend growth of the company, or growth in the price of the common stock. However, a bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common, the preferred has less security protection than the bond. However, the potential increase in the market price of the common is lacking for the preferred. One advantage of the preferred to its issuer is that the preferred receives better equity credit at rating agencies than straight debt. Also, certain types of preferred stock qualify as Tier 1 capital; this allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Through preferred stock, financial institutions are able to gain leverage while receiving Tier 1 equity credit.
If an investor paid par today for a typical straight preferred, such an investment would give a current yield of just over six percent. If, in a few years, 10-year Treasuries were to yield more than 13 percent to maturity these preferreds would yield at least 13 percent; since the rate of dividend is fixed, this would reduce their market price to $46, a 54-percent loss. The difference between straight preferreds and Treasuries is that the bonds would move up to par as their maturity date approaches; however, the straight preferred might remain at these $40 levels for a long time.
Advantages of straight preferreds may include higher yields and—in the U.S. at least—tax advantages; they yield about 2 percent more than 10-year Treasuries, rank ahead of common stock in case of bankruptcy and dividends are taxable at a maximum rate of 15% rather than at ordinary-income rates.