Preferred Stock
Now that you understand common stock, you can see how preferred stock occupies a middle ground between equity and debt. It is a hybrid security with characteristics of both.
Core Characteristics
- Pays a fixed dividend, stated as a percentage of par value or a dollar amount
- Example: 6% preferred with $100 par pays $6.00 per year
- Has dividend preference over common stock; preferred dividends must be paid before any common dividends can be declared
- Has priority over common stock in liquidation (but still subordinate to all debt holders)
- Generally does not carry voting rights
- Less price volatility than common stock
- More sensitive to interest rate changes than common stock (behaves like a bond in this respect)
| Feature | Common Stock | Preferred Stock |
|---|---|---|
| Dividends | Variable, not guaranteed | Fixed, must be paid before common |
| Voting rights | Yes (typically) | Generally no |
| Liquidation priority | Last | After debt, before common |
| Price volatility | Higher | Lower |
| Interest rate sensitivity | Lower | Higher (like bonds) |
| Upside potential | Unlimited | Limited (fixed dividend) |
Convertible Preferred Stock
Convertible preferred stock can be exchanged for a specified number of common shares at the holder's option. This feature gives preferred stockholders access to upside potential while maintaining the downside protection of a fixed dividend.
Key Conversion Terms
- Conversion ratio: The number of common shares received per preferred share upon conversion
- Conversion price: The effective price paid per common share upon conversion
- Conversion price = Par value of preferred / Conversion ratio
- Conversion value (parity): The current market value of the common shares you would receive
- Conversion value = Conversion ratio x Market price of common stock
How Convertible Preferred Trades
Convertible preferred trades at the higher of:
- Investment value: its value as straight preferred (based on the fixed dividend and prevailing interest rates)
- Conversion value: what the common shares would be worth if converted today
This creates a price floor (the investment value) with upside potential through conversion.
Think of it this way: Convertible preferred gives you a safety net (the fixed dividend) plus a ladder to climb higher (conversion into common shares). If the common stock takes off, you convert and ride the gains. If it doesn't, you keep collecting your fixed dividend.
Example
A convertible preferred share has $100 par, convertible into 4 shares of common stock:
- Conversion ratio = 4
- Conversion price = $100 / 4 = $25 per share
- If common stock trades at $30: Conversion value = 4 x $30 = $120
- If common stock trades at $20: Conversion value = 4 x $20 = $80 (preferred trades at investment value instead, since it's higher)
Exam Tip: Gotchas
Convertible preferred always trades at the higher of investment value or conversion value. If a question asks what the preferred is "worth," calculate both and pick the larger number.
Preferred Stock: Equity, Not Debt
Preferred stock looks like a bond:
- Pays fixed income (like coupon payments)
- Sensitive to interest rate changes
- Limited upside potential
- Priority claim over common stock
But preferred stock is equity, not debt:
| Feature | Preferred Stock (Equity) | Bonds (Debt) |
|---|---|---|
| Legal classification | Equity | Debt |
| Dividends/interest | Dividends (not guaranteed) | Interest (contractual obligation) |
| Tax treatment for issuer | Not deductible | Tax-deductible |
| Maturity date | None (perpetual) | Yes |
| Missed payments | No default (but arrears for cumulative) | Default / bankruptcy trigger |
Dividends-Received Deduction
While preferred dividends are not deductible by the issuing corporation, corporate investors that receive preferred dividends may benefit from the dividends-received deduction (DRD):
- Corporations owning less than 20% of the payer: 50% deduction
- Corporations owning 20% or more: 65% deduction
- Affiliated group members (80%+ ownership): 100% deduction
This makes preferred stock particularly attractive to corporate investors compared to bonds, since bond interest is fully taxable to the recipient corporation.
Exam Tip: Gotchas
Preferred dividends are NOT deductible by the issuing corporation (unlike bond interest). However, corporate investors may benefit from the 50% dividends-received deduction. The exam often tests both sides of this distinction: who pays vs. who receives.