Cumulative Dividends Most issues represent cumulative preferred stock and have a cumulative claim to dividends. That is, if preferred stock dividends are not paid in any one year, they accumulate and must be paid in total before common stockholders can receive dividends. If preferred stock carries a $10 cash dividend and the company does not pay dividends for three years, preferred stockholders must receive the full $30 before common stockholders can receive anything.
The cumulative dividend feature makes a corporation very aware of its obligation to preferred stockholders. When a financially troubled corporation has missed a number of dividend payments under a cumulative arrangement, there may be a financial recapitalization of the corporation in which preferred stockholders receive new securities in place of the dividend that is in arrears (unpaid). Assume the corporation has now missed five years of dividends under a $10-a-year obligation and the company still remains in a poor cash position. Preferred stockholders may be offered $50 or more in new common stock or bonds as forgiveness of the missed dividend payments. Preferred stockholders may be willing to cooperate in order to receive some potential benefit for the future.
2. Conversion Feature Like certain forms of debt, preferred stock may be convertible into common shares. Thus $100 in preferred stock may be convertible into a specified number of shares of common stock at the option of the holder. One new wrinkle on convertible preferreds is the use of convertible exchangeable preferreds that allow the company to force conversion from convertible preferred stock into convertible debt. This can be used to allow the company to take advantage of falling interest rates or to allow the company to change preferred dividends into tax-deductible interest payments when it is to the company’s advantage to do so. The topic of convertibility is discussed at length in Chapter 19, “Convertibles, Warrants, and Derivatives.”
3. Call Feature Also, preferred stock, like debt, may be callable; that is, the corporation may retire the security before maturity at some small premium over par. This, of course, accrues to the advantage of the corporation and to the disadvantage of the preferred stockholder. A preferred issue carrying a call provision will be accorded a slightly higher yield than a similar issue without this feature. The same type of refunding decision applied to debt obligations in Chapter 16 could also be applied to preferred stock.
4. Participation Provision A small percentage of preferred stock issues are participating preferreds; that is, they may participate over and above the quoted yield when the corporation is enjoying a particularly good year. Once the common stock dividend equals the preferred stock dividend, the two classes of securities may share equally in additional payouts.
5. Floating Rate Beginning in the 1980s, some preferred stock issuers made the dividend adjustable in nature, and this stock is classified as floating rate preferred stock. Typically the dividend is changed on a quarterly basis, based on current market conditions. Because the dividend rate changes only quarterly, there is still some possibility of a small price change between dividend adjustment dates. Nevertheless, it is less than the price change for regular preferred stock.
Investors that participate in floating rate preferred stock do so for two reasons: to minimize the risk of price changes and to take advantage of potential tax benefits associated with preferred stock corporate ownership. The price stability actually makes floating rate preferred stock the equivalent of a safe short-term investment even though preferred stock is normally thought of as long term in nature.
6. Auction Rate Preferred Stock Auction rate preferred stock is sometimes referred to as Dutch auction preferred stock, and is similar to floating rate preferred stock. Though it is actually a long-term security, it behaves like a short-term one. The auction rate preferred dividend is reset through a periodic auction that keeps the dividend yield consistent with current market conditions. The auction periods vary for each issue and can be 7, 14, 28, 49, or 91 days with some issues being reset semiannually or annually. The concept of a Dutch auction means the stock is issued to the bidder willing to accept the lowest yield and then to the next lowest bidder, and so on until all the preferred stock is sold. This is much like the Treasury bill auction held by the U.S. Treasury on a regular basis. This auction process at short-term intervals allows investors to keep up with the changing interest rates in the short-term market. Some corporate investors prefer to buy Dutch auction preferred stock because it allows them to invest at short-term rates and take advantage of the tax benefits available to them with preferred stock investments.
This type of security works well as long as there are participants at the auction willing to bid on the securities. If there are no bidders, the rate stays the same, and investors are stuck with the return until another auction can be held. One of the consequences of the financial crisis was that the auction rate securities market dried up on February 7, 2008. The auction rate market froze as large institutional investors such as Citigroup, Morgan Stanley, and Merrill Lynch failed to bid. These banks couldn’t afford to take risks on buying assets that could become illiquid, and by not bidding they created an illiquid market that many short-term investors depended upon for liquidity. This problem continued throughout 2008 and into 2009 as investors were stuck holding assets that could not be sold. Several lawsuits were filed by states, municipalities, pension funds, and by the Securities and Exchange Commission. Eventually many institutions agreed to buy back or redeem the securities at par. For all practical purposes, this market is frozen for now; maybe over time with new protections, it might recover.
7. Par Value A final important feature associated with preferred stock is par value. Unlike the par value of common stock, which is often only a small percentage of the actual value, the par value of preferred stock is set at the anticipated market value at the time of issue. The par value establishes the amount due to preferred stockholders in the event of liquidation. Also, the par value of preferred stock determines the base against which the percentage or dollar return on preferred stock is computed. Thus 10 percent preferred stock would indicate $10 a year in preferred dividends if the par value were $100, but only $5 annually if the par value were $50.
Comparing Features of Common and Preferred Stock and Debt
In Table 17-4, we compare the characteristics of common stock, preferred stock, and bonds. You should consider the comparative advantages and disadvantages of each.
In terms of the risk-return features of these three classes of securities and also of the other investments discussed earlier in Chapter 7, we might expect the risk-return patterns depicted in Figure 17-1. The lowest return is obtained from savings accounts, and the highest return and risk are generally associated with common stock. In between, we note that short-term instruments generally, though not always, provide lower returns than longer-term instruments. We also observe that government securities pay lower returns than issues originated by corporations because of the lower risk involved. Next on the scale after government issues is preferred stock. This hybrid form of security may pay a lower return than even well-secured corporate debt instruments because of the 70 percent tax-exempt status of preferred stock dividends to corporate purchasers. Thus the focus of preferred stock is not just on risk-return trade-offs but also on aftertax return.5
Next we observe increasingly high return requirements on debt, based on the presence or absence of security provisions and the priority of claims on unsecured debt. At the top of the scale is common stock. Because of its lowest priority of claim in the corporation and its volatile price movement, it has the highest demanded return.
Though extensive research has tended to validate these general patterns, short-term or even intermediate-term reversals have occurred, in which investments with lower risk have outperformed investments at the higher end of the risk scale.