The designation \u201cpreferred\u201d refers to the security\u2019s treatment relative to common shareholders. Preferred stocks dividends typically have priority over common equity dividends. Preferred securities usually have long maturities or are perpetual with no maturity at all. There are two types of preferreds stock: cumulative and non-cumulative. Non-cumulative preferred stock does not repay unpaid or omitted dividends while cumulative preferred stock entitles investors to missed dividends. If a company with cumulative preferred stock suspends its dividend, these forgone dividends accumulate and must eventually be paid to preferred shareholders.<\/p>\n\n\n\n
Why do companies issue preferreds?<\/h2>\n\n\n\n
Companies may issue preferreds for a variety of reasons:<\/p>\n\n\n\n
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- Issuing preferred shares requires a lower cost of capital than issuing common shares. Corporations value them as a way to obtain equity financing without diluting voting rights<\/li>\n\n\n\n
- Preferreds give companies flexibility in making dividend payments. If a company is running into cash issues, it can suspend the dividend payments without the risk of default as would be the case with traditional bond issuance. However, if the preferred share class is cumulative (vs. non-cumulative), then the company will still have to pay back previously skipped dividends before restarting dividends in the future<\/li>\n\n\n\n
- Preferred shares can be a balance sheet management tool, as a firm can raise capital to finance projects while not increasing its debt-to-equity ratio<\/li>\n\n\n\n
- Preferreds are issued primarily by banks and insurance companies, and preferreds can count toward regulatory capital requirements\u2014allowing banks to issue preferreds in order to help maintain their required capital ratios<\/li>\n<\/ul>\n\n\n\n
Coupon structures of preferred securities<\/h2>\n\n\n\n
Preferred securities can have a variety of different coupon structures:<\/p>\n\n\n\n
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- Fixed rate coupons<\/strong>\u00a0generally pay a specified coupon rate for life. These structures can be beneficial when rates are expected to decline as the coupon will provide constant income, even during low rate environments<\/li>\n\n\n\n
- Fixed-to-floating rate coupons<\/strong>\u00a0pay a fixed coupon for a present number of years (generally 5 to 10 years) and then convert to a floating rate coupon for the remaining life of the security or until it is called. The coupon conversion date typically coincides with a first call date, and often times the issuer will call the security instead of allowing it to begin its floating rate period. Compared to fixed-rate coupon structures, fixed-to-floating rate coupon structures typically experience less interest rate risk when rates rise<\/li>\n\n\n\n
- Floating rate coupons<\/strong>\u00a0offers a coupon that is reset at specified intervals according to a predetermined formula. Interest payments fluctuate with an underlying index or base rising rate environment and offers significantly less interest rate risk than fixed rate bonds. Many preferreds with floating rate coupons also include a floor<\/li>\n<\/ul>\n\n\n\n
If they contain a call feature, preferreds may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds: a company calls in securities that pay higher rates than what the market is currently offering. While some preferreds see refinancing with lower interest rates, many preferreds with high coupon rates remain outstanding, trading above their call prices for years due to a variety of factors that may impede the issuers from refinancing.<\/p>\n\n\n\n
Some preferred shares are convertible preferred stocks that include an option for the holder to convert the shares into a fixed number of common shares after a predetermined date. More often than not, this feature is not at the election of the holder and is instead mandatory. Mandatory convertible preferreds automatically convert to common equity on or before a predetermined date, and therefore may behave in a more equity-like fashion than other preferred security types. The value of a convertible preferred stock is ultimately based on the performance of the common stock.<\/p>\n\n\n\n
Benefits of preferred securities<\/h2>\n\n\n\n
The case for preferreds and the role they can play as a diversified income generator within portfolios, is centered on four key aspects:<\/p>\n\n\n\n
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- Potential yield<\/li>\n\n\n\n
- Tax-advantaged income potential<\/li>\n\n\n\n
- Low correlations<\/li>\n\n\n\n
- Less volatility<\/li>\n<\/ol>\n\n\n\n
Capturing potential yield<\/h3>\n\n\n\n
- Fixed-to-floating rate coupons<\/strong>\u00a0pay a fixed coupon for a present number of years (generally 5 to 10 years) and then convert to a floating rate coupon for the remaining life of the security or until it is called. The coupon conversion date typically coincides with a first call date, and often times the issuer will call the security instead of allowing it to begin its floating rate period. Compared to fixed-rate coupon structures, fixed-to-floating rate coupon structures typically experience less interest rate risk when rates rise<\/li>\n\n\n\n
- Fixed rate coupons<\/strong>\u00a0generally pay a specified coupon rate for life. These structures can be beneficial when rates are expected to decline as the coupon will provide constant income, even during low rate environments<\/li>\n\n\n\n
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