Preferred Stock and Interest Rates
With your understanding of preferred stock types and rights complete, you can now see how interest rates drive preferred stock prices, and how to calculate the yield investors actually earn.
The Inverse Relationship with Interest Rates
Because preferred stock pays a fixed dividend, its market price moves inversely with interest rates, just like bonds.
- When interest rates rise → Preferred stock prices fall
- New issues offer higher dividends, making existing lower-dividend shares less attractive
- When interest rates fall → Preferred stock prices rise
- Existing higher-dividend shares become more valuable when new issues pay less
Why This Matters for Different Types
| Type | Interest-Rate Sensitivity |
|---|---|
| Fixed-rate preferred | High - price fluctuates inversely with rates |
| Adjustable-rate preferred | Low - dividend resets to match market rates, so price stays near par |
| Callable preferred | Moderate - price rises when rates fall, but issuer may call |
Key insight: Adjustable-rate preferred has more price stability because the dividend adjusts to match market rates. Fixed-rate preferred carries more interest-rate risk because the dividend is locked in.
Exam Tip: Gotchas
- Preferred stock has no maturity date, so it cannot "pull to par" like a bond held to maturity. This makes its interest-rate risk potentially greater than a bond with the same coupon.
- Adjustable-rate preferred has lower interest-rate risk because the dividend resets to match market rates. Fixed-rate preferred carries the most interest-rate sensitivity.
Yield Calculations
Current yield is the primary yield measure for preferred stock. Because preferred stock typically has no maturity date, there is no yield to maturity (YTM) calculation.
Current Yield Formula
Current Yield = Annual Dividend / Market Price
Examples
| Scenario | Annual Dividend | Market Price | Current Yield |
|---|---|---|---|
| At par | $6.00 | $100.00 | 6.00% |
| At discount | $6.00 | $95.00 | 6.32% |
| At premium | $6.00 | $105.00 | 5.71% |
Price vs. Yield Relationship
- If preferred trades at a discount to par → Current yield is higher than the stated dividend rate
- If preferred trades at a premium to par → Current yield is lower than the stated dividend rate
- If preferred trades at par → Current yield equals the stated dividend rate
This follows the same inverse relationship as bonds: price down = yield up, price up = yield down.
Worked Example
A 5% preferred stock has a $100 par value. It currently trades at $90.
- Annual dividend = 5% x $100 = $5.00
- Current yield = $5.00 / $90.00 = 5.56%
- The stated rate is 5%, but because the investor paid less than par, the effective yield is higher
Exam Tip: Gotchas
- Current yield is the ONLY yield measure for preferred stock. There is no yield to maturity (YTM) because preferred stock typically has no maturity date.
- Discount to par = yield HIGHER than stated rate; premium = yield LOWER. If you paid less than par, you're getting the same dividend on a smaller investment, so the effective return is higher.
Investment Implications
Understanding the interest-rate relationship helps you recommend preferred stock appropriately:
- Falling rate environment: Fixed-rate preferred benefits (price appreciation + steady income)
- Rising rate environment: Adjustable-rate preferred is more appropriate (price stability)
- Callable preferred in falling rates: Issuer may call, limiting upside. The investor receives the call price but loses the income stream.
Exam Tip: Gotchas
- Callable preferred caps your upside when rates fall. The issuer will call the shares and reissue at a lower dividend rate, so the price appreciation is limited to the call price.