May 14, 2009
Types of Preferred Stock
In addition to the straight preferred, as just described, there is great 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 the same time and one of them is usually designated to be the one with the highest priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others.
Preference Preferred Stock: Ranked behind the company’s prior preferred stock (on a seniority basis), are the company’s preference preferred issues. These issues receive preference over all other classes of the company’s preferred except for the prior preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative 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 the holders can exchange for a predetermined number of the company’s common stock. This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one time deal so you cannot convert the common stock back to preferred stock.
Participating Preferred Stock: These preferred issues offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these stocks receive their regular dividend regardless of how well or how poorly the company performs, assuming of course, the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.
Cumulative Preferred Stock: If a dividend on a cumulative preferred is missed, it is not forgotten. Instead, it accumulates and must be paid off before any dividend payments are made to the common stockholders. A company can issue cumulative prior preferred, participating preference preferred or any other combination of preferred stock.
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Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock.
A single company may issue several classes of preferred stock. For example, a company 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 common stock.
In the United States there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer under certain conditions) and pay the stipulated rate of interest 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 (or, sometimes, into the common stock of an affiliated company) under certain conditions, among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common.
There are income tax advantages generally available to corporations that invest in preferred stocks in the United States that are not available to individuals.
Some argue that a straight preferred stock, being a hybrid between a bond and a stock, bears the disadvantages of each of those types of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the 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. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit.
Suppose that an investor paid par ($100) today for a typical straight preferred. Such an investment would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. (In all probability, they would yield some 2% more than the Treasuries–or something like 15%, which would take the market price down to $40, for a 60% loss.)
