Preferred Stock

Preferred stock is a hybrid security with characteristics of both equity and debt. It represents ownership but behaves more like a bond because of its fixed dividend.

Standard (Straight) Preferred

• Hybrid security - characteristics of both equity and fixed income (debt)
• Pays a fixed dividend - stated as a percentage of par value or a dollar amount
• Dividends paid before common stockholders (priority over common)
• In liquidation, preferred stockholders are paid after all debt holders but before common stockholders
• Generally no voting rights (unlike common stock)
• Par value is typically $25 or $100 per share (unlike common stock, par value matters for preferred)
• Price is sensitive to interest rate changes (like bonds) because the dividend is fixed
  • When interest rates rise, preferred stock prices fall
  • When interest rates fall, preferred stock prices rise

Think of it this way: Preferred stock sits between bonds and common stock. It pays a fixed dividend like a bond, but it has no maturity date and no promise of repayment. If rates rise, your fixed dividend looks less attractive, so the price drops, just like a bond.

Exam Tip: Gotchas

• Preferred stockholders do NOT have voting rights in most cases. If the exam asks which class of equity has voting rights, the answer is common stock. Preferred stockholders have priority for dividends and liquidation, but they trade voting rights for that priority.

Preferred Stock vs. Common Stock

Exam Tip: Gotchas

• Both common and preferred dividends require board declaration - neither is guaranteed. The difference is priority: if the board declares dividends, preferred stockholders get paid first. But the board can choose to pay no dividends at all, in which case neither class receives anything (unless cumulative preferred, where arrearages accumulate).

Types of Preferred Stock

Cumulative Preferred

• Missed (unpaid) dividends accumulate as dividends in arrears
• ALL arrearages must be paid before any dividends can be paid to common stockholders
• Provides more protection to the investor than straight preferred
• Because this feature benefits investors, cumulative preferred can be issued with a lower dividend rate than straight preferred

Participating Preferred

• Receives the stated fixed dividend PLUS a share of additional profits if the company performs well
• Extra dividends above the stated rate are shared with common stockholders
• Because this feature benefits investors, participating preferred can be issued with a lower dividend rate

Convertible Preferred

• Holder can exchange preferred shares for a fixed number of common stock shares
• Conversion ratio - the number of common shares received per preferred share
• Conversion price - the effective price per common share upon conversion (par value / conversion ratio)
• Provides equity upside while maintaining preferred dividend income
• Investor converts when the common stock price rises above the conversion price
• Because this feature benefits investors, convertible preferred can be issued with a lower dividend rate

Think of it this way: Convertible preferred gives you a safety net (fixed dividends) with an escape hatch (convert to common stock if the stock price takes off). The trade-off is a lower dividend than regular preferred.

Callable Preferred

• Issuer has the right to redeem (buy back) shares at a specified call price after a stated date
• Call feature benefits the issuer, not the investor (issuer calls when rates drop to reissue at a lower rate)
• Creates reinvestment risk for investors; proceeds must be reinvested at potentially lower rates
• Because this feature benefits the issuer (adds risk for investors), callable preferred must be issued with a higher dividend rate

Floating Rate (Adjustable Rate) Preferred

• Dividend rate adjusts periodically (typically quarterly) based on a benchmark interest rate (e.g., Secured Overnight Financing Rate (SOFR), Treasury bill rate)
• A spread is added to the benchmark rate to determine the dividend
• Significantly less interest rate risk than fixed-rate preferred because the dividend resets with market rates
• Price remains relatively stable as interest rates change (unlike fixed-rate preferred)
• May include a floor (minimum rate) and a cap (maximum rate)

Yield Trade-Off Principle

The key to understanding preferred stock types is whether the special feature benefits the investor or the issuer:

Exam Tip: Gotchas

• The yield trade-off principle is heavily tested. If a feature benefits the investor, the preferred stock can be issued at a lower dividend rate (investors accept less income for the added benefit). If a feature benefits the issuer (adds risk for investors), the preferred stock must offer a higher dividend rate to attract buyers. Callable preferred pays MORE; cumulative, participating, and convertible preferred pay LESS.

Capital Structure and Liquidation Priority

Liquidation priority determines who gets paid first when a company is dissolved.

Order of claims (first to last):

• All debt is paid before any equity: this is the fundamental rule
• Within equity, preferred always comes before common
• Common stockholders may receive nothing if assets are insufficient to cover senior claims
• Limited liability applies to both common and preferred shareholders; maximum loss is the amount invested

Exam Tip: Gotchas

• The exam may list creditors and equity holders and ask the order of payment. Remember: all debt before any equity. Within debt, secured comes before unsecured, and unsecured comes before subordinated. Preferred stock is equity, not debt; it comes after ALL creditors.