Preferred stock is a form of equity that is usually issued in addition to common stock. It is called preferred because its holders have priority over owners of common stock to receive dividends and to file property claims in bankruptcy liquidation. However, preferred stock provides limited shareholder rights and appreciation potential.
Preferred Stock Features
Preferred stocks typically pay fixed dividends, which makes them similar to other fixed-income securities such as bonds, and they sometimes have other features that could limit their upside potential. Callable preferred stock can be called, or redeemed, by the issuer at or slightly above par, which is the preferred stock’s face value. For example: A 5 percent $25 par callable preferred will pay a $1.25 annual dividend until it is called at $25.
Convertible preferred stock gives the holder the right to convert it to shares of common stock after a certain date, based on a set formula. For example, five years after the issuance, the holder of a 3 percent $100 par convertible preferred stock may convert it to three shares of common stock.
Preferred Stock Pricing
Like bonds, preferred stocks are interest-rate sensitive. Their prices move in the opposite direction of interest rates: When interest rates go up, bond and preferred stock prices go down, and vice versa. For example, if the prevailing current yield on comparable fixed-income securities is 6 percent, the 5 percent $25 par preferred would be priced around $21 to yield 6 percent.
Callable Preferred Upside Limitation
The call feature limits a preferred stock’s upside potential. If interest rates drop to 4 percent, the 5 percent $25 par callable preferred should be priced at about $31. However, since it can be called at $25, its price will rarely exceed that amount, because no investor would pay $31 for a stock that could be called from him at $25. To the extent that a callable preferred stock price can drop below par, it has the potential to appreciate to par and slightly above, depending on where the interest rates are, but by not much more.
Convertible Preferred Pricing
The closer a convertible preferred stock gets to the conversion date, the more its upside potential could be determined by the common stock’s current price. A convertible preferred stock is usually issued with a lower dividend than other types of preferreds because the conversion feature gives investors an opportunity to participate in the underlying common stock’s appreciation potential.
When a convertible preferred has just been issued, the conversion does not make sense because the underlying common stock price is too low. But if the common stock price rises above a certain level, preferred stockholders can profit from the conversion. For example: When the 3 percent $100 par convertible preferred is issued, the common stock is worth $20 a share, which would give the preferred a conversion value of $60. However, if the common stock appreciates to $50, the conversion value of the preferred will increase to $150, so the $100 par preferred would trade for about $150.
Convertible Preferred Upside Limitation
Convertible preferred is often issued after the underlying common stock has appreciated in value and investors, excited about the rise, view the preferred as an opportunity to combine current good dividend income with future capital appreciation potential. If the underlying common stock does not rise as expected, the preferred stock will continue to be priced based solely on its dividend yield.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003