Types of Preferred Stock

Most real-world preferred issues combine more than one of these features (for example, cumulative and convertible in the same issue). The exam tests each feature on its own, so learn what each one changes before you learn how they combine.

What Is Cumulative Preferred?

Cumulative preferred is the most common type of preferred stock.

• If the issuer skips a dividend payment, the unpaid amount accumulates as dividends in arrears
• All dividends in arrears must be paid to cumulative preferred shareholders before any dividends can be paid to common shareholders
• Dividends in arrears are not a liability on the balance sheet; they are disclosed in the footnotes only

How Do You Calculate Dividends in Arrears?

A common calculation is the total payout to cumulative preferred before common shareholders receive anything.

Formula: Annual dividend = Stated rate x Par value

Example: 6% cumulative preferred, $100 par value

• Annual dividend = 6% x $100 = $6.00 per share ($1.50 per quarter)
• If 2 years of dividends are skipped, dividends in arrears = $12.00 per share
• Before common shareholders receive anything, cumulative preferred must receive:
  • $12.00 (arrears) + $6.00 (current year) = $18.00 per share

Exam Tip: Gotchas

For cumulative preferred dividend questions, always pay in this order: (1) arrears FIRST, (2) current preferred dividend, (3) then common. If the total declared dividend is not enough to cover arrears plus the current preferred dividend, common gets nothing.

What Is Non-Cumulative (Straight) Preferred?

• If the issuer skips a dividend, it is gone forever; the issuer does not owe it
• Once a dividend payment date passes without a declaration, the holder has no claim to that missed payment
• Carries more risk for the investor than cumulative preferred
• Less common in practice

Key distinction: Cumulative preferred accumulates what is owed; non-cumulative preferred does not.

What Is Participating Preferred?

• Receives its stated preferred dividend first
• Then also shares in additional dividend distributions alongside common stockholders
• Effectively receives dividends twice: the fixed preferred dividend plus a pro-rata share of remaining distributions
• Rarely issued in practice
• Non-participating preferred (the default for most preferred stock) receives only the stated dividend and nothing more

Exam Tip: Gotchas

"Participating" means the preferred shareholder participates in EXTRA dividends beyond the fixed rate. Non-participating preferred (which is most preferred stock) receives only the stated dividend, regardless of how large the common dividend is.

What Is Convertible Preferred?

Convertible preferred allows the holder to exchange preferred shares for common shares at a predetermined conversion ratio.

• Conversion is at the holder's option (not the issuer's)
• Pays a lower dividend than comparable non-convertible preferred because the conversion feature has value
• Once converted, the holder gives up the preferred dividend and liquidation preference

What Are the Key Conversion Formulas?

Worked Example

$100 par preferred, conversion price $25:

• Conversion ratio = $100 / $25 = 4 shares of common
• If common trades at $30: Conversion value = 4 x $30 = $120
• Parity price of common = $100 / 4 = $25
• If common trades at $30: Parity price of preferred = $30 x 4 = $120

When Should You Convert?

• Convert when the conversion value exceeds the preferred's current market price
• If preferred trades at $100 and conversion value is $120, converting creates a $20 gain
• Investors may choose NOT to convert even when profitable, to continue receiving the higher fixed dividend stream

Exam Tip: Gotchas

Conversion is a one-way street. Once you convert preferred to common, you cannot convert back. A scenario may make conversion seem profitable, but the investor would lose the preferred dividend stream. Also remember: at parity, the preferred and its underlying common are equally valued (preferred market price = conversion value).

What Is Callable Preferred?

• Gives the issuer the right to buy back (redeem) the preferred stock at a predetermined call price
• Call price is typically at or slightly above par (e.g., $103 for $100 par)
• The issuer will call when interest rates decline (to reissue at a lower dividend rate)
• Callable preferred pays a higher dividend than non-callable preferred to compensate investors for call risk
• The investor cannot refuse the call; it is the issuer's right

Exam Tip: Gotchas

Callable = issuer's right. Convertible = holder's right. Issuers call when rates fall; holders convert when common stock rises.

What Is Adjustable-Rate (Variable-Rate) Preferred?

• Dividend rate resets periodically (typically every six months) based on a benchmark interest rate
• Because the dividend adjusts to market rates, the market price stays relatively stable near par
• Less interest-rate risk than fixed-rate preferred
• Also called floating-rate preferred

Why it matters: Adjustable-rate preferred sacrifices the certainty of a fixed payment in exchange for price stability. Investors concerned about rising rates may prefer this type.

Exam Tip: Gotchas

A question may classify variable-rate preferred under debt securities rather than equity securities, because of its bond-like, rate-reset behavior. It is still legally equity, but the exam sometimes groups it with debt instruments.

What Should You Check on Exam Day?

• Cumulative: arrears first, then current preferred, then common; if the total is short, common gets nothing.
• Non-cumulative: a skipped dividend is gone for good.
• Participating: stated dividend plus a share of extra distributions; rare in practice.
• Convertible: holder's option; lower dividend; know all four parity formulas cold.
• Callable: issuer's option; higher dividend; issuer calls when rates fall.
• Adjustable-rate: dividend resets to a benchmark, so price stays near par.