Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock, but are subordinate to bonds in terms of claim or rights to their share of the assets of the company.[1]
Preferred stock usually carries no voting rights,[2] but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Preferred stock may have a convertibility feature into common stock. Terms of the preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for preferreds is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.[3]
Contents |
Preferred stock is a special class of shares that may have any combination of features not possessed by common stock.
The following features are usually associated with preferred stock:[4]
In general, preferreds have preference to dividends payments. A preference does not assure the payment of dividends, but the company must pay the stated dividend rate prior to paying any dividends on common stock.[4]
Preferred stock can either be cumulative or noncumulative. A cumulative preferred requires that if a company fails to pay any dividend or any amount below the stated rate, it must make up for it at a later time. Dividends accumulate with each passed dividend period, which can be quarterly, semi-annually, or annually. When a dividend is not paid in time, it has "passed" and all passed dividends on a cumulative stock is a dividend in arrears. A stock that doesn't have this feature is known as a noncumulative or straight[5] preferred stock and any dividends passed are lost forever if not declared.[6]
Other features or rights
The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision,[8] enabling the issuing corporation to repurchase the share at its (usually limited) discretion.
In addition to the straight preferred, as just described, there is great diversity in the preferred stock market. Additional types of preferred stock include:
Preferred stocks offer a company an attractive alternative form of financing. In most cases, a company can defer dividends by going into arrears without much of a penalty or risk to their credit rating.[10] With traditional debt, payments are required and a missed payment would put the company in default.
Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange or conversion features that exercise upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as takeover defense (see also poison pill). These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous supervoting powers.
When a corporation goes bankrupt, there might be enough money to repay holders of those preferred issues that are known as "senior", but not enough money for "junior" issues. So when the preferred shares are first issued, sometimes their prospectuses (contracts) contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu (equal) or junior relationship with other series issued by the same corporation.
Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock.
A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have "Series A Preferred," "Series B Preferred," "Series C Preferred" and common stock.
In the United States, there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer under certain conditions) and pay the stipulated rate of interest to the holder. Convertible preferreds—in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions, among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common.
There are income tax advantages generally available to corporations that invest in preferred stocks in the United States that are not available to individuals.
Some argue that a straight preferred stock, being a hybrid between a bond and a stock, bears the disadvantages of each of those types of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit.
Suppose that an investor paid par ($100) today for a typical straight preferred. Such an investment would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. The important difference between straight preferreds and Treasuries (or any investment-grade Federal agency or corporate bond) is that the bonds would move up to par as their maturity date is approached, whereas the straight preferred, having no maturity date, might remain at these $40 levels (or lower) for a very long time.
Advantages of straight preferreds posited by some advisers include higher yields and tax advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather than at ordinary income rates, as in the case of bond interest).
Preferred shares represent a significant portion of Canadian capital markets, with over CAD 5-billion in new preferred shares issued in 2005.[2]
Many Canadian issuers are financial organizations that may count capital raised in the preferred share market as Tier 1 capital, provided that the shares issued are perpetual. Another class of issuer are "split share corporations."
Investors in Canadian preferred shares are generally those who wish to hold fixed-income investments in a taxable portfolio. Preferential tax treatment of dividend income, as opposed to interest income, may in many cases result in a greater after-tax return than might be achieved with bonds.
Preferred shares are often used by private corporations to achieve Canadian tax objectives. For instance, the use of preferred shares can allow a business to accomplish an estate freeze. By transferring common shares in exchange for fixed value preferred shares, business owners can allow future gains in the value of the business to accrue to other persons (like a family trust).
Preference shares in German stock exchanges is usually indicated with V, VA or Vz, short for Vorzugsaktie, for example "BMW Vz",[11] in contrast to St or StA, short for Stammaktie for standard shares.[12]
Preferred stock may amount to up to half of the total equity. Preferred stock is convertible into common stock, but conversion needs approval by majority vote in the stockholders' meeting. If the vote passes, German law requires consensus with preferred stock holders to convert their stock, which is usually encouraged by offering a one-time premium to preferred stock holders. The firm's intention to do so may arise from its finance policy i.e. ranking in a specific index. Industry stock exchange indices usually do not consider preferred stock in determining daily trading volume of a company's stock e.g. do not qualify the company for a listing due to the low trading volume in (just common) stocks.
Perpetual non-cumulative preference shares may be included as Tier 1 capital. Perpetual cumulative preferred shares are Upper Tier 2 capital. Dated preferred shares (normally having an original maturity of at least five years) may be included in Lower Tier 2 capital.[13]
In the United States issuance of publicly listed preferred stock is generally limited to financial institutions, REITs and public utilities. Because in the US dividends on preferred stock are not tax deductible at the corporate level (in contrast to interest expense), the effective cost of capital raised by preferred stock is 35% greater than issuing the equivalent amount of debt at the same interest rate. This has led to the development of TRuPS (Trust-preferred security) which are essentially debt instruments with the same properties as preferred stock. With the passage of Dodd-Frank in 2010 Trust Preferred Securities will be phased out as a vehicle for raising Tier 1 capital by bank holding companies. Outstanding issues of Trust Preferreds will be phased out completely by 2015.[14]
However, with a qualified dividend tax of 15% compared to a top ordinary marginal tax rate of 35%,[15] $1 of dividend income taxed at these rates provides the same after-tax income as approximately $1.30 in interest.
The size of the preferred stock market in the United States has been estimated as US$100-billion, as of early 2008[update], compared to US$9.5 trillion for equities and US$4.0 trillion for bonds.[16]
|
|||||||||||||||||||||||||