Preferred stock
Overview
 
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
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

, but are subordinate to bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 in terms of claim or rights to their share of the assets of the company.

Preferred stock usually carries no voting rights, but may carry a dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

 and may have priority over common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

 in the payment of dividends and upon liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...

.
Encyclopedia
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
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

, but are subordinate to bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 in terms of claim or rights to their share of the assets of the company.

Preferred stock usually carries no voting rights, but may carry a dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

 and may have priority over common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

 in the payment of dividends and upon liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of 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.

Features

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:
  • Preference in dividend
    Dividend
    Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

    s.
  • Preference in assets in the event of liquidation
    Liquidation
    In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...

    .
  • Convertible into common stock.
  • Callable at the option of the corporation.
  • Nonvoting.


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.

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
Arrears
Arrears is a legal term for the part of a debt that is overdue after missing one or more required payments. The amount of the arrears is the amount accrued from the date on which the first missed payment was due...

. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared.

Other features or rights
  • Preferred stock may or may not have a fixed liquidation value
    Liquidation value
    Liquidation value is the likely price of an asset when it is allowed insufficient time to sell on the open market, thereby reducing its exposure to potential buyers. Liquidation value is typically lower than fair market value...

    , or par value
    Par value
    Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....

    , associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued.
  • Preferred stock has a claim on liquidation
    Liquidation
    In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...

     proceeds of a stock corporation
    Stock corporation
    A stock corporation is a for-profit corporation which the ownership of the corporation is expressed by shares of stock. This allows for the ownership of the corporation to be readily determined, as shares are property, and are transferrable as any other property such as money, subject to any...

    , equivalent to its par or liquidation value unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim
    Residual claimant
    In economics, the residual claimant is the agent who receives the net income .Residual claimancy is generally required in order for there to be moral hazard, which is a problem typical of information asymmetry. This is specifically the case for the principal–agent problem....

    .
  • Almost all preferred shares have a negotiated fixed dividend
    Dividend
    Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

     amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends on preferred shares may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR.
  • Some preferred shares have special voting right
    Right
    Rights are legal, social, or ethical principles of freedom or entitlement; that is, rights are the fundamental normative rules about what is allowed of people or owed to people, according to some legal system, social convention, or ethical theory...

    s to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time.


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, enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

Types of preferred stock

In addition to the straight preferred, as just described, there is great diversity in the preferred stock market. Additional types of preferred stock include:
  • Prior Preferred Stock—Many companies have different issues of preferred stock outstanding at the same time and one of them is usually designated to be the one with the highest priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others.

  • Preference Preferred Stock—Ranked behind the company's prior preferred stock (on a seniority basis), are the company's preference preferred issues. These issues receive preference over all other classes of the company's preferred except for the prior preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative seniority. One issue is designated first preference, the next senior issue is the second and so on.

  • Convertible Preferred Stock—These are preferred issues that the holders can exchange
    Embedded option
    An Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options...

     for a predetermined number of the company's common stock. This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one-way deal so one cannot convert the common stock back to preferred stock.

  • Cumulative preferred stock—If the dividend is not paid, it will accumulate for future payment.

  • Exchangeable preferred stock—This type of preferred stock carries an embedded option
    Embedded option
    An Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options...

     to be exchanged for some other security upon certain conditions.

  • Participating Preferred Stock
    Participating Preferred Stock
    Participating preferred stock is preferred stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. This form of financing is used by private equity investors and venture...

    —These preferred issues offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these stocks receive their regular dividend regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend.

  • Perpetual preferred stock—This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date.

  • Putable preferred stock—These issues have a "put
    Put option
    A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...

    " privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares.

  • Monthly income preferred stock
    Monthly income preferred stock
    Monthly income preferred stock or MIPS is a hybrid security created by Eli Jacobson, a Sullivan & Cromwell tax partner, and introduced to the market by Goldman Sachs in 1993...

    —A combination of preferred stock and subordinated debt
    Subordinated debt
    In finance, subordinated debt is debt which ranks after other debts should a company fall into receivership or bankruptcy....

    .

  • Non-cumulative preferred stock—Dividend for this type of preferred stock will not accumulate if it is unpaid. Very common in TRuPS and bank preferred stock, since under BIS
    Bank for International Settlements
    The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

     rules, preferred stock must be non-cumulative if it is to be included in Tier 1 capital
    Tier 1 capital
    Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...

    .

Typical usage

Preferred stocks offer a company an attractive alternative form of financing. In most cases, a company can defer dividends by going into arrears
Arrears
Arrears is a legal term for the part of a debt that is overdue after missing one or more required payments. The amount of the arrears is the amount accrued from the date on which the first missed payment was due...

 without much of a penalty or risk to their credit rating. 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
Poison pill
A shareholder rights plan, colloquially known as a "poison pill", or simply "the pill" is a type of defensive tactic used by a corporation's board of directors against a takeover...

). These shares may be assigned very high liquidation value that must be redeemed
Redemption value
Redemption value is the price at which the issuing company may choose to repurchase a security before its maturity date.A bond is purchased at a discount if its redemption value exceeds its purchase price. It is purchased at a premium if its purchase price exceeds its redemption value....

 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
Prospectus (finance)
In finance, a prospectus is a document that describes a financial security for potential buyers. A prospectus commonly provides investors with material information about mutual funds, stocks, bonds and other investments, such as a description of the company's business, financial statements,...

 (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
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

.

Users

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 bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

s are encouraged to issue preferred stock as a source of Tier 1 capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...

. On the other hand, the Tel Aviv Stock Exchange
Tel Aviv Stock Exchange
The Tel Aviv Stock Exchange in Tel Aviv is Israel's only stock exchange.The TASE is the only public market for trading securities in Israel. It plays a major role in the Israeli economy....

 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).

Canada

Preferred shares represent a significant portion of Canadian capital markets, with over CAD 5-billion in new preferred shares issued in 2005.http://www.ida.ca/Files/Media/MediaRelease/General/MRG2006020601_en.pdf

Many Canadian issuers are financial organizations that may count capital raised in the preferred share market as Tier 1 capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...

, provided that the shares issued are perpetual. Another class of issuer are "split share corporation
Split share corporation
A split share corporation is a corporation that exists for a defined period of time to transform the risk and investment return of a basket of shares of conventional dividend-paying corporations into the risk and return of the two or more classes of publicly traded shares in the split share...

s."

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
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

.

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).

Germany

Preference shares in German stock exchanges is usually indicated with V, VA or Vz, short for , for example "BMW Vz", in contrast to St or StA, short for for standard shares.

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.

United Kingdom

Perpetual non-cumulative preference shares may be included as Tier 1 capital
Tier 1 capital
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...

. Perpetual cumulative preferred shares are Upper Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...

. Dated preferred shares (normally having an original maturity of at least five years) may be included in Lower Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...

.

United States

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
Trust-preferred security
A trust-preferred security is a security possessing characteristics of both equity and debt issues. A company creates trust-preferred securities by creating a trustissuing debt to the new entity, while the trust issues the trust preferred securities...

) 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.

However, with a qualified dividend tax
Dividend tax
A dividend tax is an income tax on dividend payments to the stockholders of a company.-Collection:In many jurisdictions, the government requires the company to withhold at least the standard tax, paying this to the national revenue authorities and paying out only the balance to the...

 of 15% compared to a top ordinary marginal tax rate
Marginal tax rate
In a tax system and in economics, the tax rate describes the burden ratio at which a business or person is taxed. There are several methods used to present a tax rate: statutory, average, marginal, effective, effective average, and effective marginal...

 of 35%, $1 of dividend income taxed at these rates provides the same after-tax income as approximately $1.30 in interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

.

The size of the preferred stock market in the United States has been estimated as USD$100-billion, , compared to USD$9.5 trillion for equities and USD$4.0 trillion for bonds.

Other countries

  • Czech Republic – Preferred stock cannot be more than 50% of total equity.
  • France – By a law that dates from June 2004, France allows the creation of preferred shares.
  • South Africa – Dividends from preference shares are not taxable as income in the hands of individuals.
  • Brazil – In Brazil, up to 50% of the capital stock of a company may be composed of preferred stock. The preferred stock will have at least one less right than the common stock (normally voting power) but will have preference in receiving dividends.

External links

  • "The Many Flavors of Preferred Stock" at About.com
    About.com
    About.com is an online source for original information and advice. It is written in English, and is aimed primarily at North Americans. It is owned by The New York Times Company....

The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
x
OK