Preferred Stock

The fixed dividend

A preferred share carries a stated dividend, expressed either as a percentage of par or as a dollar amount. Par for preferred stock is conventionally $100 unless a question says otherwise, and unlike common stock's par it is economically meaningful: it is the base for the dividend calculation and, typically, the liquidation preference.

A 6 percent preferred with a $100 par pays $6.00 a year, usually quarterly at $1.50. If the same issue is quoted at $80 in the market, its current yield is $6.00 divided by $80, or 7.5 percent. That calculation — annual dividend over market price — is the same one you will use for bonds in Module 3, and the exam uses it in both places.

What the preference actually buys is priority, not certainty. Preferred dividends must be paid before any dividend is paid on common. They still require a board declaration; a board that declares nothing pays nothing, and preferred holders generally have no vote and therefore no direct remedy. What they usually do have is a contractual consequence: many issues grant preferred holders voting rights, often the right to elect directors, once dividends have been in arrears for a specified number of periods.

In liquidation, preferred ranks ahead of common and behind every class of creditor.

The feature types

Cumulative preferred. Any dividend not paid accumulates in arrears and must be paid in full — all of it, from every missed period — before any common dividend is paid. A question that gives you three missed years on a $5 cumulative preferred and one current year is asking for $20 per share before common sees anything. Non-cumulative preferred simply loses a skipped dividend permanently, which is why nearly all retail-distributed preferred is cumulative.

Participating preferred. In addition to its stated dividend, it shares in additional distributions, typically alongside common up to a stated cap. Rare in practice, common on exams.

Convertible preferred. Exchangeable for common at a stated conversion ratio or conversion price. The ratio is par divided by the conversion price: a $100 par preferred convertible at $25 converts into four shares. Convertible preferred trades on the greater of its value as a fixed-income instrument and its parity value as equity — parity being the market value of the common the preferred converts into. Because the conversion feature has value, convertible preferred is issued at a lower stated dividend than an otherwise identical straight preferred. That trade-off is the exam's favourite convertible question in every asset class.

Callable preferred. The issuer may redeem it, usually at par or a small premium, after a stated call protection period. Calls happen when rates have fallen and the issuer can refinance more cheaply — which is precisely when the holder least wants to be redeemed. Callability therefore requires the issuer to pay a higher dividend than an otherwise identical non-callable issue.

Adjustable-rate and variable-rate preferred. The dividend resets periodically against a benchmark rate. Because the payment moves with rates, the price is far more stable than a fixed-rate issue — this is the answer when a question asks which preferred has the least price volatility in a changing rate environment.

Prior or senior preferred. Ranks ahead of other preferred issues of the same company for dividends and liquidation.

Why it trades like a bond

A straight preferred pays a fixed amount forever and has no maturity. Its value is therefore a perpetuity: the annual dividend divided by the yield the market demands. When required yields rise, the price falls; when they fall, the price rises. The relationship is exactly the inverse price-yield relationship you will meet in Module 3, and because there is no maturity date pulling the price back toward par, a straight preferred is more rate-sensitive than most bonds, not less.

This produces a set of exam answers worth memorising as a group. In a rising-rate environment, the most vulnerable holdings are long-maturity, low-coupon and no-maturity instruments — long zero-coupon bonds and straight preferred. The most defensive are short maturities and floating-rate instruments — Treasury bills, adjustable-rate preferred, money market funds.

There is one advantage that belongs to preferred and not to bonds, and it is not for the retail customer. A corporation holding another corporation's preferred stock may exclude a substantial portion of the dividends received from taxable income under the dividends-received deduction. Interest on a corporate bond gets no such treatment. This is why corporate treasurers are structural buyers of preferred stock, and it is the reason an exam question about who benefits most from holding preferred stock has a corporate rather than an individual answer.