Preferred Stock

Preferred stock occupies a middle ground between the fixed, bond-like income you studied in fixed income units and the unlimited upside of common stock covered in the previous lesson. Convertible preferred blends both worlds by adding an option to become common stock.

What Are the Core Characteristics of Preferred Stock?

• 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: if the board declares a dividend, preferred is paid before any common dividend. "Fixed" refers to the rate, not a guarantee of payment; the board must still declare each dividend, and skipping a preferred dividend is not a default the way a missed bond interest payment is
• 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)

Exam Tip: Gotchas

Preferred stock's fixed dividend describes the rate, not a promise to pay. A missed preferred dividend is not a default the way a missed bond coupon is, even though both are described as "fixed."

What Happens When a Company Skips a Preferred Dividend?

Skipping a preferred dividend is not a default, but it is not always free either. One feature decides whether the company still owes the missed payment later.

• Cumulative preferred: missed dividends pile up as dividends in arrears. The company must pay every arrearage, plus the current preferred dividend, before it can pay any common dividend
• Noncumulative (straight) preferred: a missed dividend is forfeited permanently. The holder never recovers it, and the company can resume common dividends after paying only the current preferred dividend
• Most preferred stock issued today is cumulative, so treat cumulative as the default unless the question says otherwise

Worked example: a company issues 6% cumulative preferred with a $100 par value, then skips the dividend for two years. Before it may pay any common dividend it owes $12 in arrears ($6 per year for two years), plus the current $6, for $18 per share.

Exam Tip: Gotchas

• No interest accrues on a dividend in arrears. The company owes the skipped dollar amount itself, not that amount plus a yield. Arrears are not a debt obligation, and unpaid arrears still do not put the company in default.
• Only cumulative preferred creates arrears. When a question says "straight" or "noncumulative," the missed dividend is gone for good, so any answer that has the company making it up later is wrong.

What Other Preferred Features Are Tested?

Exam Tip: Gotchas

• Callable is an issuer right and convertible is a holder right. Each feature benefits whoever holds the option, so a callable issue pays a higher dividend rate to compensate the buyer, while a convertible issue pays a lower one because the buyer is paying for the upside.

What Is Floating Rate Preferred Stock?

The "fixed" in the section above has one exception. Floating rate preferred resets its dividend rate periodically against a reference rate, instead of holding one rate for the life of the issue.

That single change reverses the interest rate behavior:

• Because the payment adjusts toward prevailing rates, the price is less sensitive to interest rate changes than fixed rate preferred
• Fixed rate preferred behaves like a long bond. Floating rate preferred does not

It is still preferred stock in every other respect: dividend and liquidation preference over common, generally no voting rights, and the board must still declare each dividend.

Exam Tip: Gotchas

Interest rate sensitivity is the tested contrast between the two. A question that describes a preferred issue holding its value while rates move is describing floating rate preferred. Do not carry the "preferred behaves like a bond" rule across to it.

How Does Convertible Preferred Stock Work?

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.

What Are the 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

At What Price Does Convertible Preferred Trade?

Convertible preferred trades at the higher of:

1. Investment value: its value as straight preferred (based on the fixed dividend and prevailing interest rates)
2. 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 rate) 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 the preferred and its declared dividends.

What Does a Worked Example Look Like?

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.

Why Is 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:

How Does the Dividends-Received Deduction Work?

Preferred dividends are not deductible by the issuing corporation, but 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 but less than 80%: 65% deduction
• Affiliated group members (80%+ ownership): 100% deduction

This makes preferred stock relatively attractive to corporate investors compared to bonds, since bond interest received is fully taxable to the recipient corporation.

Exam Tip: Gotchas

Preferred dividends are NOT deductible by the issuing corporation (unlike bond interest). Corporate investors, however, may benefit from the dividends-received deduction. This tests both sides of the distinction: who pays vs. who receives.

What Should You Check on Exam Day?

• Preferred stock is equity, not debt, even though it behaves like a bond in price sensitivity and a fixed dividend rate.
• Preferred dividends have priority over common but are not guaranteed; skipping one is not a default. Cumulative preferred accrues arrears payable before any common dividend; noncumulative forfeits it. Liquidation order: debt, preferred, common.
• Floating rate preferred resets its dividend against a reference rate, so it is less sensitive to interest rate changes than fixed rate preferred; the bond-like behavior applies to the fixed rate version.
• Convertible preferred trades at the higher of its investment value or its conversion value (conversion ratio x market price of common).
• The issuing corporation cannot deduct preferred dividends, but a corporate holder may qualify for the dividends-received deduction depending on its ownership stake in the payer.