The following article is reprinted from the July/August, 2000 issue of
On the Edge, the CMS bimonthly newsletter.

Back to Basics: Preferred Stock

Teri Geske
Senior Vice President, Product Development

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Many of our clients now hold preferred stock in their portfolios. These bond-like instruments can offer attractive after-tax returns, as much of the income from a preferred holding is usually exempt from corporate taxation (more about this later). In many ways, preferreds are equivalent to bonds; then again, there are certain characteristics of preferreds that are definitely not “bond-like.” So, for fixed income professionals who may be looking at preferred stocks as a new asset class, this Back-to-Basics column will help you navigate through the characteristics and risk/return profile of this hybrid instrument.

First, we’ll examine the attributes of preferreds and the vocabulary used to describe them. Since these instrument are somewhere between debt and equity, it is only fitting that the terminology for preferreds comes from both the equity and fixed income markets. Like bonds, preferreds have a face or “par” value that is payable at maturity. Unlike bonds, this par value is usually not $1,000; it is often $25, $50, or $100. Preferreds offer investors a periodic cash payment at a stated percent of face value, much like a bond’s coupon. However, if the issuer fails to make this payment it does not constitute a default - typically an unpaid preferred dividend is viewed as cumulative, to be paid at some future date. Furthermore, the dividend on preferred shares is often paid quarterly, more like a stock dividend than the typical semi-annual coupon payment on U.S. corporate bonds.

Another equity-like feature of the preferred’s dividend is that it is paid to the owner of record as of a certain date, the ex-dividend date. So, unlike the bond market where accrued interest is always paid by the buyer to the seller when a transaction occurs between interest payment dates, if a preferred is sold between the ex-dividend date and the dividend payment date, the seller will still receive the entire dividend when it is paid. Thus, a preferred stock transaction that occurs between an ex-dividend date and the dividend payment date does not include any accrued dividend amount. Since, the expected pay-out on a preferred share is similar in many respects to the common stock dividend that is promised to equity holders, it is therefore not surprising that a preferred stock’s payout is called a “dividend,” not a “coupon.”

Earlier we mentioned that a preferred’s par value is paid to the investor at maturity. Of course, one of the most important distinctions between stocks and bonds is that a bond constitutes a promise of repayment at some “maturity” date. Although preferreds would therefore appear to be debt-like in this respect, some preferreds are “perpetual” and have no stated maturity date. In theory, this suggests that the perpetual preferred stock issuer pays dividends to investors for all eternity without ever repaying the par value; however, in reality most, if not all perpetual preferreds are callable, so the issuer does have some way of retiring the issue. Many preferreds also have mandatory sinking funds, requiring that a certain percentage of the issue be called at the per-share par value each year. Some preferreds are convertible into some number of shares of the issuer’s common stock at the investor’s option, providing an equity “kicker” to this fixed income-like instrument.

Price and Yield - a number of choices
When preferreds are traded, the price is typically quoted as a “full” (or “dirty”) price that includes the accrued dividend. This is consistent with the way common stock prices are quoted. On the ex-dividend date, the price drops to reflect the fact that the buyer would not be entitled to the receive the dividend pay-out. Investors may also compute a Strip Price, which is the price excluding the dividend. This price is less commonly quoted than the full price, but is used in some yield calculations. When computing the yield on a preferred stock, a number of different yields may be used: Current Yield - the annual dividend divided by the full price, a measure commonly used in the equity markets; Strip Yield - similar to the current yield, but based on the strip price, i.e., the annual dividend divided by the strip price; Yield-to-Call/Sink - the yield-to-worst, based on a the Full Price and any mandatory sinking fund schedule and/or call option; Strip Yield-to-Call/Sink - same as the Yield-to-Call/Sink, but based on the Strip Price.

In addition to all of these yield measures, investors are often interested in computing the yield of a preferred stock on a “taxable-equivalent” basis. As mentioned earlier, the dividend received on most preferreds is largely exempt from taxation for corporate investors; presently, corporations that hold preferreds as investments do not pay taxes on 70% of the dividends received (note: Trust Preferreds do not qualify for this exemption). This exemption is called the Dividends-Received Deduction or DRD, and it makes the preferred’s dividend more valuable to a corporate investors than an equivalent coupon payment on a taxable bond. The amount of the tax advantage is a function of the corporation’s tax rate; the higher the tax rate, the more valuable the DRD. Consider a preferred stock priced at par, with dividend payout of $5 per share, and assume a corporate investor has a tax rate of 33%. Since 70% or $3.50 of this $5 dividend is exempt from taxes, the corporation pays 33% taxes on only $1.50, or $0.50. So, the corporation keeps $4.50 of every $5 dividend, compared to only 67% or $3.33 of every $5 coupon received on a bond. By combining the DRD of 70% with the corporate tax rate, we can compute a Discount Factor that is used to “gross up” the Strip Yield of a preferred to a taxable equivalent strip yield.

Now that we have covered the vocabulary and price/yield conventions for preferreds, we briefly address the interest rate, credit and liquidity risks for these securities. Like a bond, preferreds offer a predictable set of cash flows (unless a dividend goes unpaid). Therefore, a preferred’s price is sensitive to a change in interest rates that affect the present value of these expected future cash flows, and we can compute duration and convexity as interest rate risk measures for preferred stock just as we do for bonds. However, duration and convexity may not completely explain a preferred’s price behavior; changes in tax rates, or even changes in expectations regarding tax rates, will also affect the demand for and thus prices of preferreds. Credit risk is also an important element of a preferred stock’s risk/return characteristics. The credit risk of a preferred is greater than that of a bond issued by the same company, not only because an unpaid preferred dividend is not considered to be a default, but also because preferred shareholders have a junior claim on the firm’s assets in the event of a bankruptcy. Thus, the credit rating on a preferred will almost always be one or possibly two steps below the rating on the issuer’s senior debt and yields on preferreds should reflect this higher credit risk. Finally, most preferreds are listed on one or more exchanges and thus may enjoy greater liquidity than many bonds; however, there is no guarantee of an active market for preferreds, even though they are exchange-traded.

In summary, preferreds offer bond-like payouts with potentially attractive yields (albeit with greater credit risk) and substantial tax advantages to corporate investors. The vocabulary of the preferred market borrows from the equity markets and may be somewhat confusing to a fixed income portfolio manager; however, there is usually some logic behind the terminology. As a reminder, preferred stocks can be incorporated in all of your BondEdge portfolio analyses including Cashflow Testing scenarios. If you’d like to suggest a topic for a future Back-to-Basics column, we’d like to hear from you: Please email Teri Geske, at teri.geske@be.ftid.com with your comments or suggestions.