Types of Preferred Stock
Now that you understand the fundamentals, let's examine the six types of preferred stock the exam tests. Each type adds a specific feature that changes the risk/reward profile for the investor or the issuer.
Cumulative Preferred
Cumulative preferred is the most common type of preferred stock, and the exam's favorite for dividend calculation questions.
- 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
Calculating Dividends in Arrears
The exam frequently presents scenarios requiring you to calculate the total payout before common gets 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
The exam loves 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.
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.
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.
Convertible Preferred
Convertible preferred allows the holder to exchange preferred shares for common shares at a predetermined conversion ratio. This is one of the most frequently tested types on the Series 7.
- 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
Key Formulas
| Formula | Calculation |
|---|---|
| Conversion ratio | Par value / Conversion price |
| Conversion value | Conversion ratio x Common stock market price |
| Parity price of common | Preferred market price / Conversion ratio |
| Parity price of preferred | Common stock market price x Conversion ratio |
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 to Convert
- Convert when the conversion value exceeds the preferred market price (or par value if bought at par)
- 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. The exam may present scenarios where it seems profitable to convert, but the investor would lose the preferred dividend stream. Also remember: parity price tells you the breakeven point where converting is neither a gain nor a loss.
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
| Feature | Callable Preferred | Convertible Preferred |
|---|---|---|
| Who holds the option? | Issuer | Holder |
| When is it exercised? | Rates fall | Common stock rises |
| Dividend impact | Higher (compensates for risk) | Lower (conversion has value) |
Exam Tip: Gotchas
Callable = issuer's right. Convertible = holder's right. The exam tests whether you know who has the option. Issuers call when rates fall; holders convert when common stock rises.
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.