What are the types of preferred stock? Among many investment instruments with a low risk like bonds and mutual funds there is also a preferred stock. Most important kinds of preferred stock are: straight, convertible and variable.
Straight Preferred Stock
Straight preferred stock is an equity security that has many of the same characteristics as fixed income securities. Most preferred stocks pay a fixed dividend rate in much the same way that traditional bonds pay fixed, predetermined interest payments. It may be a good choice for investors who currently hold tax deferred and tax-advantaged accounts (such as IRAs), or who have steady income requirements. Its advantages are:
• fixed quarterly dividend rate,
• attractive yields compared to common stock equivalents,
• high credit quality,
• low minimum investment,
• liquidity (most are listed on major stock exchanges).
In addition to straight preferred stock, which pays a fixed dividend rate over the life of the equity, some preferred stock is structured with features that may be important if an investor wants to participate in any rise in the stock market or take advantage of any favorable interest rate fluctuations.
Convertible Preferred Stock
Among many types of preferred stock there is also a convertible preferred stock that has a fixed dividend rate; however, the stockholder has the option of converting the securities into a set number of common shares of stock according to terms set forth at issuance. Investors can then participate in any rise in the issuing company’s stock, yet still receive some protection against any drop in the common stock price. An example of convertible preferred stock is a Preference Equity Redemption Cumulative Stock (PERCS).
PERCS is a preferred stock issued by a company in order to raise capital without raising debt. It is well-suited to equity investors who are willing to forego some upside appreciation in exchange for current income. Simply, a PERCS is a class of preferred stock that pays a higher dividend than the issuing company’s common stock (dividend yield is dependent on market conditions and prevailing interest rates at the time of the initial offering), has a cap price above the common stock price (usually 30% – 40% above the common stock price), and has a finite life span of approximately three years. The dividends are paid quarterly.
During the life of the security, the issuing company has the right to redeem the PERCS. This could happen if the common stock price rallied to exceed the cap price. In this circumstance, the investor would receive the cap price in common stock in addition to the value of any uncollected dividends.
At the termination date, if the price of the company’s common stock is below the cap price, the preferred shares will convert to common stock on a one-for-one basis. If, however, the common stock is trading above the cap price the investor will receive a fraction of one share or the equivalent of the cap price divided by the stock price. For example, if XYZ is trading at $20 at termination, the holder of XYZ PERCS with a cap price of $10, will receive one-half of a share of XYZ common stock-cap price (10) divided by stock price (20) for each preferred share. This formula ensures that the investor will receive the cap price for the preferred shares.
It is important to note that because a PERCS eventually turns into common stock, it is subject to the risk that the price may decline. During the life of the PERCS, the downside risk is offset somewhat by the current income that the PERCS investor receives from the preferred dividend. However, the investor should be moderately bullish on the issuing company because the PERCS, which provides the current yield today, will ultimately convert into the common stock of the issuing company. Obviously, the most bullish investment is to invest directly in the common stock of the issuing company.
Variable (Adjustable) Rate Preferred Stock
Adjustable rate preferred stock has a dividend rate that is readjusted periodically according to predetermined guidelines. Investors have some assurance that their investment will benefit from any rise in interest rates, but they also risk that their income will decrease if rates fall. The minimum capital required ranges from $1500 to $2500.