CHAPTER
TWENTY-THREE
NONCONVERTIBLE PREFERRED STOCK
Professor of Finance
Moore School of Business
University of South Carolina
Preferred stock is a hybrid security that combines features of both common stocks and corporate bonds. While preferred stock possesses some debtlike features, it is considered to be an equity security. Preferred stockholders have a claim on the cash dividends paid by the issuing corporation, and their claim is senior to that of common shareholders. Furthermore, cash dividends paid to preferred stockholders are almost always fixed by contract (e.g., a specified dollar amount or percentage of their face value). Accordingly, “plain vanilla” preferred stock is, in essence, a perpetuity. The specified percentage is called the dividend rate, which may be fixed or floating. Almost all preferred stock issued today limits the payments to be received by the security holder to a specified amount with the proviso that the cash flows received will never exceed those specified in the contract and may be less.
Failure to make preferred stock dividend payments cannot force the issuer into bankruptcy. If the issuer fails to make the preferred dividend payments as specified in the contract, then depending on the terms of the issue, one of two things can occur. If the issue is cumulative, the dividend payment accrues until it is fully paid. Conversely, if the issue is noncumulative, missed dividend payments simply are forgone. Failure to make dividend payments also may trigger certain restrictions on the issuer’s management. As an example, if dividend payments are in arrears, preferred shareholders may be granted voting rights to elect some members to the issuer’s board of directors. This feature is called contingent voting because the voting rights are contingent on a missed dividend payment.1
Cumulative preferred stock has some debtlike features, namely (1) the cash flows promised to preferred stockholders are fixed by contract, and (2) preferred stockholders have priority over common stockholders with respect to dividend payments and distribution of the assets in case of bankruptcy.2 However, on a balance sheet, preferred stock is classified as equity. When there is more than one class of preferred stockholders, the claims of preferred stockholders to the issuer’s assets differ in the event of bankruptcy. For example, first preferred stock’s claim to dividends and assets has priority over other preferred stock. Correspondingly, second preferred stock ranks below at least one other issue of preferred stock.
Almost all preferred stock has a sinking-fund provision, and such provisions usually are structured similarly to those used with corporate bonds. A sinking fund is a provision allowing for a preferred stock’s periodic retirement over its life span. Most sinking funds require a specific number of shares or a certain percentage of the original issue to be retired periodically, usually on an annual basis. Sinking-fund payments can be satisfied by either paying cash and calling the required number of shares or delivering shares purchased in the open market. Most sinking funds give the issuer a noncumulative option to retire an additional amount of preferred stock equal to the mandatory requirement. This is called a double-up option. Preferred shares acquired to satisfy a sinking-fund requirement usually are called using a random selection process.
Preferred shares offer investors two distinct advantages over debt and other equity investments. Preferred shares offer higher yields on average than bonds or common stock. Moreover, preferred shares provide good diversification benefits owing to their low correlation with stocks and bonds. In order to obtain these benefits, investors in preferred stocks must contend with the risk characteristics of these securities. Preferred share possess limited potential for price appreciation. The reason being is that the lion’s share of the total return is due to the stream of dividend payments. Naturally this raises the specter of default risk meaning a breach in the contract with the preferred stockholder like omission of a dividend. According to Moody’s, out of the 1,802 preferred shares rated over the period 1983–2008, 118 issues experienced a dividend omission which means it was not declared in either the amount or at the regular dividend date specified in the prospectus.3 Some preferred shares are callable which exposes the investor to reinvestment risk. Finally, preferred stocks tend to be less liquid than common stocks.
PREFERRED STOCK ISSUANCE
Corporations use three types of securities—debt, common stock, and preferred stock—to finance their operations. In terms of total dollars issued, preferred stock ranks third by a large margin. There have been two fundamental shifts in the issuance pattern of preferred stock since the early 1980s. Since the mid-1980s, the major issuers of preferred stock are financial institutions and insurance companies, whereas before this time, public utilities issued a majority of preferred stock. Second, most of the preferred stock issued today carries an adjustable-rate dividend. Traditionally, almost all preferred stock paid a fixed dividend.
Types of Preferred Stock
There are three types of preferred stock: (1) fixed-rate preferred stock, (2) adjustable-rate preferred stock, and (3) auction-rate and remarketed preferred stock.
Fixed-Rate Preferred Stock
Prior to 1982, all publicly issued preferred stock paid a fixed dividend rate. As an example, consider some fixed-rate preferred stock issued by Carolina Power and Light issued in 1955. These shares carry a $4.20 annual dividend paid quarterly. The issue is callable in whole or in part on May 26, 2011 at a price of $102 per share.
Adjustable-Rate Preferred Stock
For adjustable-rate preferred stock (ARPS), the dividend rate is reset quarterly based on a predetermined spread from the highest of three points on the Treasury yield curve. The predetermined spread is called the dividend reset spread. The dividend reset spread is added to or subtracted from the benchmark rate determined from the yield curve. The three points on the yield curve are the highest of (1) the 3-month Treasury bill rate, (2) the 10-year Treasury rate, or (3) the 30-year Treasury rate. It is often the case that the dividend reset spread is expressed as a certain percentage of the benchmark rate. As an example, HSBC USA Corp. issued preferred stock in May 1994 for which the dividend rate was 83% of the highest of the 3-month U.S. Treasury rate, the 10-year Constant Maturity Treasury rate, and the 30-year Constant Maturity Treasury rate. In addition, the dividend rate had a cap of 10.5% and a floor of 4.5%. This issue was callable on May 26, 2011, at the issue price of $25 per share. The motivation for linking the dividend rate to the highest of the three points on the Treasury yield curve is to provide the preferred shareholder with some protection against unfavorable shifts in the yield curve.
Auction-Rate and Remarketed Preferred Stock
Most ARPS is perpetual, with a cap and floor on the dividend rate. Because most ARPS is not putable, however, ARPS can trade below par value after issuance if the spread demanded by the market as compensation for the risk of the security is greater than the dividend reset spread. The popularity of ARPS declined when these instruments began trading below their par value. This occurs because when an issuer’s credit risk deteriorates, the dividend-rate formula remains unchanged and the preferred stock’s value will decline. In 1984, a new type of preferred stock was issued to overcome this problem—auction-rate preferred stock. This innovation was particularly well received by corporate investors who sought tax-advantaged short-term instruments to invest excess funds. The dividend rate on auction-rate preferred stock is reset periodically, but the dividend rate is established through a Dutch auction process. Participants in the auction consist of current preferred shareholders as well as potential buyers. The dividend rate that participants are willing to accept reflects current market conditions. Commercial paper rates typically serve as benchmarks. As an example, Advent Claymoore issued auction rate preferred stock in September 2007 with a par amount of $25,000. The reset frequency is 7 days. This issue is subject to mandatory redemption and is callable on dividend payment dates.
In the case of remarketed preferred stock, the dividend rate is determined periodically by a remarketing agent, who resets the dividend rate so that any preferred stock can be tendered at par and be resold (remarketed) at the original offering price. An investor has the choice of dividend resets every 7 days or every 49 days. As an example, consider some remarketed preferred stock issued by DNP Select Income Fund, a closed-end fund, in December 1988. Note three facts about the issue. First, the dividend is reset every 49 days. Second, there is a mandatory redemption date of December 11, 2024. Third, the issue is callable on any payment date at par (i.e., $100,000) plus accrued dividends.
TRUST PREFERRED
Trust preferred securities are hybrid securities primarily issued by financial institutions with features of both debt and equity. They are treated as debt for tax purposes such that dividend payments are tax deductible and may be deferred up to five years. Conversely, they are treated as Tier I capital for trust preferred securities are senior to both preferred and common stock but subordinate to all debt. These securities possess 30-year maturities allowing for early redemption at the behest of the issuer. Trust preferred shares generally deliver quarterly dividend payments.
In the aftermath of the financial crisis of 2007–08, regulators lamented financial institutions were too highly levered and that more regulation was paramount. These changes in regulation were delivered in two packages—Basel III and the Dodd-Frank Act. Endorsed by the G-20, the Basel III banking standards are to be enacted by member nations through either regulation or statue by January 1, 2013. The Dodd-Frank Act was signed into law and represents the most significant U.S. financial reform since the Depression. Both packages of regulation raise capital standards and phase out trust preferred from Tier 1 capital. Basel III generally gives a much longer phase out period than the three years stipulated by Dodd-Frank. The other important difference in the treatment of trust preferred stock is that Dodd-Frank exempts small banks from the phase out. Basel III contains no such exemption.
PREFERRED STOCK RATINGS
Preferred stock is rated just like corporate bonds. A preferred stock rating is an assessment of the issuer’s ability to make timely dividend payments and fulfill any other contractually specified obligations (e.g., sinking-fund payments). The three nationally recognized statistical rating organizations (NRSROs) that rate corporate bonds also rate preferred stock. The NRSROs are Fitch Ratings, Moody’s Investors Service, Inc., and Standard & Poor’s Ratings Group. Symbols used by the NRSROs for rating preferred stock are the same as those used for rating corporate long-term debt. It is important to note that the rating applies to the security issue in question and not to the issuer per se. Two different securities issued by the same firm could have different ratings. Standard & Poor’s attaches +s and –s, which are called notches, to denote an issue’s relative standing within the major ratings categories.4
The Dodd-Frank Act requires U.S. regulatory agencies to remove all references to security credit ratings from their rules and regulations. U.S. regulatory agencies are tasked with the development of an alternative to the ratings agencies. As of mid 2011, progress has been scant. It is widely agreed the process will take considerable time and effort to complete.
TAX TREATMENT OF DIVIDENDS
Dividend payments made to preferred stockholders are treated as a distribution of earnings. This means that they are not tax deductible to the corporation under the current tax code.5 Interest payments are tax deductible, not dividend payments. While this raises the after-tax cost of funds if a corporation issues preferred stock rather than borrowing, there is a factor that reduces the cost differential: a provision in the tax code exempts 70% of qualified dividends from federal income taxation if the recipient is a qualified corporation. For example, if corporation A owns the preferred stock of corporation B, for each $100 of dividends received by A, only $30 will be taxed at A’s marginal tax rate. The purpose of this provision is to mitigate the effect of double taxation of corporate earnings.
The tax treatment of preferred stock also differs depending on whether it is classified as old money, new money, or partial money. Old money refers to preferred stock issued before October 1, 1942. For old money preferred stock, the dividend-received deduction is only 42%. Partial money refers to a very small new set of issues that were classified as both old and new money. Old and partial money comprise only a tiny fraction of the preferred stock outstanding today. In other words, virtually all preferred stock outstanding today is new money.
There are two implications of this tax treatment of preferred stock dividends. First, the major buyers of preferred stock are corporations seeking tax-advantaged investments. Indeed, very few individual investors hold preferred stock in their portfolios. Second, the cost of preferred stock issuance is lower than it would be in the absence of the tax provision because the tax benefits are passed through to the issuer by the willingness of corporate investors to accept a lower dividend rate.
KEY POINTS
• Preferred stock is a hybrid security that combines elements of debt and equity.
• Preferred shares offer higher yields on average than bonds or common stock and provide good diversification benefits owing to their low correlation with stocks and bonds.
• Preferred share possess limited potential for price appreciation and are exposed to default risk.
• There are three types of preferred stock: (1) fixed-rate; (2) adjustable-rate; and (3) auction-rate.
• Trust preferred securities are hybrid securities primarily issued by financial institutions with features of both debt and equity. They are treated as debt for tax purposes such that dividend payments are tax deductible and may be deferred up to five years.