chapter 12 preferred stocks wcitigroup …wps.aw.com/wps/media/objects/3853/3945845/preferred...what...

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What do Alltel (telecommunications),Citigroup (financial institution), VirginiaElectric and Power (utility), Six Flags(theme parks), HRPT Properties Trust

(real estate), and NeoRx (biotechnology) share in common?Though their industries and market capitalizations vary widely,all of these companies issue preferred stock. This investmentcategory is enjoying renewed popularity in the face of volatilecommon stock prices, historically low bond yields, and moneymarket funds with return rates of less than 1%. Investors lookingfor income-producing securities were attracted to preferred yieldsthat could reach 10% and averaged 7.1% in mid-December 2003,compared to about 6% for high-quality log-term corporate bonds.

Many individual investors are taking a hard look at the rolethat preferred stock can play in their portfolios. Preferred stock is generally issued with a $25 par value, as opposed to $1,000 for most corporate bonds, placing these equities well within thereach of the average investor. In fact, individual investors aremajor buyers of preferreds, which contributes to these stocks’price stability.

In addition to the traditional preferred stocks that pay fixed dividends, you can buy other forms such as adjustable-rate preferreds, trust preferreds (which pay interest rather thandividends), and convertible preferreds that can be turned intocommon stock. This wide range of options makes buying preferredstock more difficult than you might think. Two Web sites thatoffer quotes and other information worth checking out arePreferred Stock Online (www.preferredstockonline.com) andQuantumOnline.com (www.quantumonline.com). In this chapter,you’ll learn about preferred stock and other hybrid investments,such as convertible securities, and the advantages they offerinvestors.

Sources: Jeffrey R. Kosnett and Courtney McGrath, “Aim High,” Kiplinger’s Personal FinanceMagazine, February 2003, p. 38; David Landis, “Juicy Yields from Quirky Stocks,” Kiplinger’sPersonal Finance Magazine, November 1, 2003; pp. 58, 60; and Jeff D. Opdyke and TomHerman, “Wall Street Pushes Preferred Stock; Tax Cut Spurs Interest in Dividend-RichShares, But Many Don’t Qualify for New Low Rate,” The Wall Street Journal, August 19,2003, p. D1.

C H A P T E R 1 2

PREFERRED STOCKSAND CONVERTIBLE

SECURITIES

After studying this chapter, you should be able to:

Describe the basic features ofpreferred stock, including sources of valueand exposure to risk.

Discuss the rights and claims ofpreferred stockholders, and note some of thepopular issue characteristics that are oftenfound with these securities.

Understand the various measures of investment worth, and identify severalinvestment strategies that can be used withpreferred stocks.

Identify the fundamentalcharacteristics of convertible securities, and explain the nature of the underlyingconversion privilege.

Describe the advantages anddisadvantages of investing in convertiblesecurities, including their risk and returnattributes.

Measure the value of a convertiblesecurity, and explain how these securities can be used to meet different investmentobjectives.

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LEARNING GOALS

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What would you think of a stock that promised to pay you a fixed annual div-idend for life—nothing more, nothing less? If you’re an income-orientedinvestor, the offer might sound pretty good. But where would you find such aninvestment? Right on the NYSE or AMEX, where hundreds of these securitiestrade every day, in the form of preferred stock—a type of security that lookslike a stock but doesn’t behave like one. In the first two sections of this chapterwe will look at preferred stock as an investment vehicle. In the third andfourth sections we will turn our attention to convertible securities. These aresecurities originally issued as bonds (or preferred stock) that later can be con-verted into shares of the issuing firm’s common stock. Both of these investment

vehicles—preferred stock and convertibles—are forms of fixed-income corporate securities. As you’ll see in the chapter, bothare also hybrid securities, meaning they contain elements ofboth debt and equity.

Preferred stocks carry fixed dividends that are paid quar-terly and are expressed either in dollar terms or as a percentageof the stock’s par (or stated) value. They are used by companies

that need money but don’t want to raise debt to get it; in effect, they are widelyviewed by issuers as an alternative to debt. Companies like to issue preferredsbecause they don’t count as common stock (and, therefore, don’t affect EPS).However, being a form of equity, they don’t count as debt, either—and there-fore don’t add to the company’s debt load. There are today nearly a thousandOTC and listed preferred stocks outstanding. Many of them are issued bypublic utilities, although the number of industrial, financial, and insuranceissues is rapidly increasing.

Preferred Stocks as Investment Vehicles

Preferred stocks are available in a wide range of quality ratings, from invest-ment-grade to highly speculative. Table 12.1 provides a representative sampleof some actively traded preferred stocks. It shows the types of annual divi-dends and dividend yields that these securities were providing in August 2003.

Advantages and Disadvantages Without a doubt, the number one reasonthat investors are attracted to preferred stocks is the current income they pro-vide. Take another look at Table 12.1—note the very attractive dividend yields

these securities offer. Such returns compare favorably to thoseavailable on other fixed-income securities and dividend-payingcommon stocks, and they explain in large part why income-oriented investors are so attracted to these investment vehicles.Another reason for investing in these securities is the level ofsafety they offer investors. That is, despite a few well-publicizedincidents, high-grade preferred stocks have an excellent recordof meeting dividend payments in a timely manner—certainly an

important consideration to income-oriented investors. A final advantage is thelow unit cost ($25 to $50 per share) of many of the issues, which gives evensmall investors the opportunity to actively participate in preferreds.

While preferreds do, indeed, pay hefty dividends, most of them unfortu-nately do not qualify for the new preferential tax rate (of 15% or less). The

Preferred Stocks

502 PART FOUR I INVESTING IN FIXED-INCOME SECURITIES

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preferred stocka stock that has a prior claim(ahead of common) on theincome and assets of the issuing firm.

H O T L I N K SFor more information on preferred stock, seeLearning Center at Briefing.com at:

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reason: During the 1990s, Wall Street created a new type of preferred stock,so-called trust preferreds, that actually qualified as debt for tax purposes—meaning the dividends paid by the issuer could be treated as a tax-deductibleexpense. As a result, what was initially intended as a big windfall for the issuerhas turned into a big disadvantage for investors. Right now, it’s estimated thatabout two-thirds of all outstanding preferred stocks don’t qualify for the newtax treatment, though that’s expected to change as the more traditional pre-ferred stocks (which pay dividends from after-tax profits) start making acomeback. Until then, let the buyer beware!

Another drawback of preferred stocks is their susceptibility to inflation andhigh interest rates. That is, like many other fixed-income securities, preferredstock values go down when rates go up. Thus, these securities simply havenot proved to be satisfactory long-term hedges against inflation. Still anotherdisadvantage is that preferred dividends may be suspended, or “passed,” if theearnings of the corporate issuer drop off. Unlike the coupon payments on abond, dividends on preferreds have no legal backing, and failure to pay themdoes not lead to default. Preferreds also lack substantial capital gains potential.Although it is possible to enjoy fairly attractive capital gains from preferredstocks when interest rates decline dramatically, these amounts generally do notmatch the price performance of common stocks.

Sources of Value With the exception of convertible preferreds, the value ofhigh-grade preferred stocks is a function of the dividend yields they provide.More specifically, the value (or market price) of a preferred stock is closelyrelated to prevailing market rates: As the general level of interest rates movesup, so do the yields on preferreds, and their prices decline accordingly. Wheninterest rates drift downward, so do the yields on preferreds, as their pricesrise. Just like bond prices, therefore, the price behavior of a high-grade pre-ferred stock is inversely related to market interest rates. Moreover, its price isdirectly linked to the issue’s level of income. That is, other things being equal,the higher the dividend payment, the higher the market price of an issue. Thus,the price of a preferred stock can be defined as follows:

CHAPTER 12 I PREFERRED STOCKS AND CONVERTIBLE SECURITIES 503

TABLE 12.1 A Sample of Some High-Yielding Preferred Stock

Annual Market Dividend Issuer Dividend Price Yield

AT&T $2.06 $25.38 8.1%Alabama Power 1.46 24.95 5.9Bank One 2.13 27.70 7.7Citigroup 3.12 52.20 6.0Cleveland Electric 2.25 26.65 8.4Disney 1.75 25.70 6.8El Paso Energy 2.38 30.00 7.9Host Marriott 2.50 22.20 11.3Nova Chemical 2.26 24.95 9.1Public Storage Co. 2.44 27.43 8.9

Note: All of these issues are straight (nonconvertible) preferred stocks traded on the NYSE. All the information that appears in this table was obtained in August 2003.

Source: Wall Street Journal, August 11, 2003.


Equation 12.1

This equation is simply a variation of the standard dividend yield formula,but here we solve for the price of the issue. (You might also detect a similaritybetween this formula and the zero-growth dividend valuation model intro-duced in Chapter 8—see Equation 8.7.) The equation shown here (12.1) isused to price preferred stocks and to compute the future price of a preferred,given an estimate of expected market yields. For example, a $2.50 preferredstock (meaning the stock pays a dividend of $2.50 per year) would be priced at$20.83 if the prevailing market yield were 12%:

Note that as market yield decreases, you get higher preferred stock prices, thusgiving you the inverse relationship between price and yield.

The yield that a preferred stock offers (and therefore its market value) is afunction of not only market interest rates but also the issue’s credit quality:The lower the quality of a preferred, the higher its yield. Such behavior is, ofcourse, compatible with the risk-return tradeoffs that usually exist in the mar-ketplace. Fortunately, preferred stocks are rated, much like bonds, by Moody’sand Standard & Poor’s. Finally, the value of a preferred is also affected byissue characteristics such as call features and sinking-fund provisions. Forexample, freely callable preferreds normally provide higher yields than non-callable issues because of their greater call risk. Quality and issue features,however, have only slight effects on price behavior over time, and they cer-tainly do not compare in importance with the movement of market yields.

Risk Exposure Preferred stock investors are exposed to both business andinterest rate risks. Business risk is important with preferreds, because thesesecurities are a form of equity ownership and, as such, lack many of the legalprotections of bonds. Annual operating costs and corporate financial strength,therefore, are of concern to preferred stockholders. Preferred stock ratings(discussed later in the chapter) can be used to assess the amount of businessrisk embedded in an issue. Higher-quality/higher-rated issues are believed topossess less business risk.

Because of the fixed-income nature of these securities and the way they’revalued in the market, interest rate risk is also important to preferred stock-holders. That is, when market interest rates move up, the value of these securi-ties (like that of bonds) falls. Indeed, such risk exposure can be very damagingif interest rates move against you in a big way.

Market Transactions Preferred stocks are subject to the same transactioncosts (brokerage fees and transfer taxes) as shares of common stock. In addi-tion, preferred stock investors use the same types of orders (market, limit, andstop-loss) and operate under the same margin requirements. And in somenewspapers, even the quotes for preferred stocks are commingled with those ofcommon. However, as can be seen in Figure 12.1, the Wall Street Journal has a separate listing for preferred stock quotes, which includes the name of the

��Price 5$2.500.12

5 $20.83

��Price of a preferred stock 5Annual dividend incomePrevailing market yield


CAN YOU “TRUST”PREFERREDS?—Not all stocklabeled “preferred” paydividends; in fact, trustpreferreds pay interest. Forexample, Citigroup issues bothtypes of preferreds: F-classshares, which pay dividends of 6.365% and have a parvalue of $50; and S-classshares, which pay interestincome of 6% and have a par value of $25. Because ofthe different tax treatmentaccorded to dividends andinterest income, the after-taxyields for these stocks will be considerably different. Infact, with the new lower ratefor qualified dividends,traditional preferred stocks,whose dividends are eligiblefor the new 15% (or lower)rate, carry a big advantageover trust preferreds, whoseincome is taxed at ordinaryincome rates.

Source: Jeff D. Opdyke, “What toKnow about Preferred Stock,” San Diego Union-Tribune, August 24, 2003, p. H5; andQuantumOnline.com, downloadedfrom www.quantumonline.com,accessed November 24, 2003.


stock, the amount of annual dividends, the dividend yield, closing price, andchange in price.

Also, note that a single company can have any number of preferred stockissues outstanding, each with its own annual dividend. Certainly, that’s thecase with the Citigroup preferreds. The quotes in Figure 12.1 show, forexample, that there are nine issues of preferred stock listed for Citigroup.Actually, the company may have even more preferred issues outstanding, but ifthose issues did not trade on the day of the quotes, they would not be listed.Citigroup’s preferreds pay annual dividends of anywhere from $1.50 to $3.18per share. (Note that, generally speaking, the higher the annual dividend, thehigher the price of the stock.) At quoted market prices, these preferreds wereproviding current yields of 5.8% to 6.9%. Observe also the relatively low unitcost of the stock. With very few exceptions, preferred stocks usually trade ataround $25 to $50 a share.

Issue Characteristics

Preferred stocks possess features that not only distinguish them from othertypes of securities but also help differentiate one preferred from another. Forexample, preferred stocks may be issued as convertible or nonconvertible,although the majority fall into the nonconvertible category. A convertible pre-ferred has a conversion feature that allows the holder to convert the preferredstock into a specified number of shares of the issuing company’s common stock.Because convertible preferreds are, for all intents and purposes, very much like


FIGURE 12.1Published Quotes for Preferred StockIn publications like the WallStreet Journal, preferred stockquotes are listed separately fromcommon stocks. Many companieshave more than one issue ofpreferred outstanding, in whichcase, each issue is identifiedalphabetically, such as pfF, pfG,etc. (Source: Wall Street Journal,August 11, 2003.)

Citigroup’spreferredstocks

STOCK DIV YLD CHGCLOSECinnBell pfB 3.38 9.0 37.70 0.22Citigroup pfF 3.18 6.0 53 –0.50Citigroup pfG 3.11 6.0 52.25 0.15Citigroup pfH 3.12 6.0 52.20 0.20Citigroup pfM 2.93 5.8 50.64 –0.01Citigroup pfS 1.50 6.1 24.46 0.12Citigroup pfV 1.78 6.8 26.24 0.19Citigroup pfW 1.75 6.9 25.37 0.14Citigroup pfX 1.72 6.7 25.62 0.13Citigroup pfZ 1.74 6.8 25.72 0.21CtznUtil Tr 2.50 5.0 5.0 ...ClevelandElec 2.25 8.4 26.65 0.05ClvdElec pfL 7.00 7.0 100.50 0.50ColonlProppfD .51p ... 25.84 0.29ColonlProppfC 2.31 8.5 27.19 0.14ComcastHldg 1.43 4.9 29 ...ComercaCappfZ 1.90 7.3 26.14 0.18ComrclRlty pf 2.25 8.4 26.69 0.39ConAgraCappfB 1.25 5.0 24.85 –0.01

PREFERRED STOCK LISTINGS

conversion featureallows the holder of a convertiblepreferred to convert to a specifiednumber of shares of the issuingcompany’s common stock.

Gitm.6858.ch12.501-538.ctp 3/15/04 8:38 AM 05

convertible bonds, we will discuss them later in the chapter. At this point, we’llconcentrate on nonconvertible issues, although many of the features we areabout to discuss apply equally to convertible preferreds. In addition to convert-ibility, investors should be aware of several other important features of pre-ferred stocks; they include the rights of preferred stockholders and the specialprovisions (such as those pertaining to passed dividends or call features) thatare built into preferred stock issues.

Rights of Preferred Stockholders The contractual agreement of a preferredstock specifies the rights and privileges of preferred stockholders. The mostimportant of these deal with the level of annual dividends, the claim onincome, voting rights, and the claim on assets. The issuing company agrees

that it will pay preferred stockholders a (minimum) fixed levelof quarterly dividends and that such payments will take priorityover common stock dividends. The only condition is that thefirm generate income sufficient to meet the preferred dividendrequirements. However, the firm is not legally bound to pay div-idends. Of course, it cannot pass dividends on preferred stock

and then pay dividends on common stock. To do so would violate the pre-ferreds’ prior claim on income.

Although most preferred stocks are issued with dividend rates that remainfixed for the life of the issue, in the early 1980s some preferreds began toappear with floating dividend rates. Known as adjustable-rate (or floating-rate) preferreds, these issues adjust their dividends periodically in line withyields on specific Treasury issues, although minimum and maximum dividendrates are usually established as a safeguard for investors and issuers.

Even though they hold an ownership position in the firm, preferred stock-holders normally have no voting rights. However, if conditions deteriorate tothe point where the firm needs to pass one or more consecutive quarterly divi-dends, preferred shareholders are usually given the right to elect a certainnumber of corporate directors so that their views can be represented. And ifliquidation becomes necessary, the holders of preferreds are given a prior claimon assets. These preferred claims, limited to the par or stated value of the stock,must be satisfied before the claims of the common stockholders. Of course, thisobligation does not always mean that the full par or stated value of the pre-ferred will be recovered, because the claims of senior securities (like bonds)must be met first. That is, all bonds (including convertible bonds) have a higherclaim on assets (and income) than preferred stock, whereas preferreds have ahigher claim than common stock. Thus preferred shareholders have a claimthat’s somewhere between that of bondholders and common stockholders.

Finally, when a company has more than one issue of preferred stock out-standing, it sometimes issues preference (or prior preferred) stock. Essentially,this stock has seniority over other preferred stock in its right to receive divi-dends and in its claim on assets in the event of liquidation. Therefore, pref-erence stocks should be viewed as senior preferreds. They’re usually easy topick out in the financial pages because they use the letters pr instead of pf intheir quotes.

Preferred Stock Provisions There are three preferred stock provisions thatinvestors should be well aware of before making an investment in a preferredsecurity. Especially important is the obligation of the issuer in case any divi-


adjustable-rate (floating-rate) preferredspreferred stock whose dividendsare adjusted periodically in linewith yields on certain Treasuryissues.

preference (prior preferred) stocka type of preferred stock that has seniority over other preferredstock in its right to receivedividends and in its claim on assets.

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dends are missed. In addition, you should determine whether the stock has acall feature and/or a sinking fund provision. Let’s start by looking at howpassed dividends are handled, which depends on whether the preferred stock isissued on a cumulative or a noncumulative basis.

Fortunately for investors, most preferred stocks are issued on a cumula-tive basis. This means that any preferred dividends that have been passed mustbe made up in full before dividends can be paid to common stockholders. Anyoutstanding unfulfilled preferred dividend obligations are said to be in arrears,and so long as dividends on preferred stock remain in arrears, a corporationmay not make dividend payments on common shares. Assume, for example,that a firm normally pays a $1 quarterly dividend on its preferred stock buthas missed the dividend for three quarters in a row. In this case, the firm haspreferred dividends in arrears of $3 a share. It must meet these past dividends,along with the next quarterly dividend, before it can pay dividends tocommon shareholders. The firm could fulfill this obligation by paying, say,$2 per share to the preferred stockholders at the next quarterly dividend dateand $3 per share at the following one (with the $3 covering the remaining$2 in arrears and the current $1 quarterly payment). If the preferred stockhad carried a noncumulative provision, the issuing company would have beenunder no obligation to make up any of the passed dividends. Of course,the firm could not make dividend payments on common stock either. But itcould resume such payments simply by meeting the next quarterly preferreddividend. Other things being equal, a cumulative preferred stock should bemore highly valued than an issue without such a provision. That is, the cumu-lative feature should increase the price (and in so doing, lower the yield) ofthese issues.

Since the early 1970s, it has become increasingly popular to issue pre-ferred stocks with call features. Today, a large number of preferreds carry thisprovision, which gives the firm the right to call the preferred for retirement.Callable preferreds are usually issued on a deferred-call basis, which meansthey cannot be retired for a certain number of years after the date of issue.After the deferral period, usually 5 to 7 years, the preferreds become freelycallable. Of course, such issues are then susceptible to call if the market ratefor preferreds declines dramatically. This explains why the yields on freelycallable preferreds should be higher than those on noncallable issues. As withbonds, the call price of a preferred is made up of the par value of the issue anda call premium that may amount to as much as one year’s dividends.

Another preferred stock feature that has become popular is the sinking-fund provision. This provision specifies how all or a part of an issue will bepaid off—amortized—over time. Sinking-fund preferreds actually haveimplied maturity dates. They are used by firms to reduce the cost of financing,because sinking-fund issues generally have lower yields than nonsinking-fundpreferreds. A typical sinking-fund preferred might require the firm to retirehalf the issue over a 10-year period by retiring, say, 5% of the issue each year.Unfortunately, the investor has no control over which shares are called forsinking-fund purposes. Sinking-fund provisions not withstanding, many pre-ferred issues today actually have explicit maturity dates. These began toappear in the 1990s, when, as noted earlier, Wall Street started creating trustpreferred stocks that qualified as debt for tax purposes. So, as is customarywith bonds, preferred stocks also started coming out with maturity dates, mostof which were very lengthy—often 30 to 50 years.


cumulative provisiona provision requiring that anypreferred dividends that havebeen passed must be paid in fullbefore dividends can be restoredto common stockholders.

in arrearshaving outstanding unfulfilledpreferred dividend obligations.

noncumulative provisiona provision found on somepreferred stocks excusing theissuing firm from having to make up any passed dividends.

HOW TO HIDE FROM RISINGRATES—One of the biggestfears of fixed-income investors(including preferred stockinvestors) is rising interestrates. To hedge against risingrates, investors often turn to adjustable-rate preferreds,whose cash dividends areadjusted quarterly to reflectmarket conditions. Thedividends on adjustablepreferreds usually have a floorand a ceiling, but that stillleaves plenty of room to moveup or down with market rates.When rates move up, ratherthan the price of the issuegoing down, the dividendpayment goes up instead.Bottom line: There’s far less price volatility withadjustables than with fixed-rate preferreds.


I N R E V I E W

12.1 Define a preferred stock. What types of prior claims do preferred shareholdersenjoy? How do trust preferreds differ from traditional preferreds?

12.2 In what ways is a preferred stock like equity? In what ways is it like a bond?

12.3 What are the advantages and the disadvantages of investing in preferreds?

12.4 Distinguish a cumulative preferred from a callable preferred. Do cumulative div-idend provisions and call features affect the investment merits of preferredissues? Explain.

As we just saw, although preferred stocks may be a form of equity, they behavein the market more like a bond than a stock. Therefore, it seems logical thatpreferreds should be valued much like bonds, with market interest rates andinvestment quality playing key roles. Similarly, when it comes to investing inpreferreds, you would expect interest rates (either the level of market interestrates or the movements therein) to play key roles in preferred stock investmentstrategies. In fact, that’s exactly what you find: The two most widely used pre-ferred stock strategies involve either going after high levels of current incomeor seeking capital gains when market rates are falling.

Putting a Value on Preferreds

Evaluating the investment suitability of preferreds involves assessing compara-tive return opportunities. Let’s look now at some of the return measures thatare important to preferred stockholders, and then at the role that agency rat-ings play in the valuation process.

Dividend Yield: A Key Measure of Value Dividend yield is critical to deter-mining the price and return behavior of most preferred stocks. It is computedaccording to the following simple formula:

Equation 12.2

Dividend yield is a measure of the amount of return earned on annual divi-dends, and is the basis upon which comparative preferred investment opportu-nities are evaluated. (It is basically the same as the dividend yield used inChapter 7 with common stocks and is comparable to the current yield measureused with bonds, as described in Chapter 11.)

Here’s how dividend yield works: Suppose an 8% preferred stock has a parvalue of $25 and is currently trading at a price of $27.50 per share. For pre-ferreds whose dividends are denoted as a percentage of par (or stated) value,the dollar value of the annual dividend is found by multiplying the dividendrate (in this case, 8%) by the par value ($25). Thus, the annual dividend on thisstock is 0.08 3 $25 5 $2. Therefore, the dividend yield in this example is

��Dividend yield 5Annual dividend income

Current market price of the preferred stock

Valuing andInvesting inPreferreds


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dividend yielda measure of the amount of returnearned on annual dividends.


As you can see, at $27.50 a share, this preferred is yielding about 7.3% toinvestors. If the price of this preferred moves down (to say, $21 a share), the

dividend yield increases (in this case, to about 91⁄2%). In practice,we would expect investors to compute or have available a cur-rent dividend yield measure for each preferred under considera-tion and then to make a choice by comparing the yields on thealternative preferreds—along with, of course, the risk and issuecharacteristics of each.

Expected Return Whereas long-term investors may consider dividend yield akey factor, that’s not necessarily the case with the short-term traders. Instead,these traders generally focus on anticipated price behavior and the expectedreturn from buying and selling an issue over a short period of time. Thus theexpected future price of a preferred is important to short-term traders.Expected price can be found by first forecasting future market interest ratesand then using that information to determine expected future price. To illus-trate, suppose a preferred stock pays $3 in dividends and its yield is expectedto decline to 6% within the next 3 years. If such market rates prevail, then 3 years from now, the issue will have a market price of $50 (using Equa-tion 12.1, annual dividend 4 yield 5 $3 4 0.06 5 $50). This forecasted price,along with the current market price and level of annual dividends, would thenbe used in either the expected return or holding period return formula to assessthe return potential of the investment.

To continue with our example, if the stock were currently priced at $28 ashare, it would have an expected return (over the 3-year investment horizon)of a very attractive 30.3%. This can be found by using the IRR approach wefirst introduced in Chapter 4 and then applied (as a measure of expectedreturn) to common stocks in Chapter 8 and to bonds in Chapter 11. Basically,you’d want to find the discount rate, in the present-value-based yield formula,that equates the expected future cash flows from this preferred to its currentmarket price of $28 a share. (The preferred’s cash flows are the $50 price in 3years, plus the annual dividends of $3 a share over each of the next 3 years.)As it turns out, that discount rate equals 30.3%; at that rate, the present valueof the future cash flows amounts to $28 a share. (As an aside, this problem can readily be solved with a financial calculator by letting N 5 3, PV 5 28,PMT 5 23, FV 5 250 and then solve for I. Try it. You should end up with avalue (return) of 30.34.)

You now have a measure of the relative attractiveness of this preferredstock. Of course, other things (like risk) being equal, the higher the expectedreturn, the more appealing the investment. (Note that if the above perform-ance had occurred over a period of 6 months, rather than 3 years, you woulduse the holding period return measure to assess the potential return of this pre-ferred. See Chapter 4 for details.)

Book Value The book value (or net asset value) of a preferred stock is ameasure of the amount of debt-free assets supporting each share of preferredstock. In this regard, note that it’s the total book value of the firm that’s of

��Dividend yield 5$2

$27.505 7.27%


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book value (net asset value)a measure of the amount of debt-free assets supporting each shareof preferred stock.


concern here, not just the amount of preferred equity listed on the balancesheet. That’s because, relative to common equity, preferred shareholders have aprior claim on all the net assets of the firm. Thus, book value per share is foundby subtracting all the liabilities of the firm from its total assets and dividing thedifference by the number of preferred shares outstanding. This measure, inessence, reflects the quality of an issue with regard to the preferred’s claim onassets. Obviously, a preferred with a book value of $150 per share enjoysgenerous asset support and more than adequately secures a par value of, say,$25 a share. Net asset value is most relevant when it is used relative to anissue’s par (or stated) value. Other things being equal, the quality of an issueimproves as the margin by which book value exceeds par value increases.

Fixed Charge Coverage Fixed charge coverage is a measure of how well a firmis able to cover its preferred dividends. Here attention is centered on the firm’sability to service preferred dividends and live up to the preferred’s preferentialclaim on income. As such, fixed charge coverage is important in determiningthe quality of a preferred stock. Fixed charge coverage is computed as follows:

Equation 12.3

Note in this equation that preferred dividends are adjusted by a factor of 0.65.This adjustment is used with “traditional” preferred stocks and takes intoaccount the fact that a company pays dividends from the earnings that are leftafter taxes. The adjustment factor (0.65) implies a corporate tax rate of 35%,which is a reasonable rate to use for our purposes here. By making the indi-cated adjustment, you essentially place preferred dividends on the same basisas interest paid on bonds, which is a tax-deductible expense. Normally, thehigher the fixed charge coverage, the greater the margin of safety. A ratio of1.0 means the company is generating just enough earnings to meet its pre-ferred dividend payments—not a very healthy situation. A coverage ratio of0.7 suggests the potential for some real problems, whereas a coverage of, say,7.0 indicates that preferred dividends are fairly secure.

As noted with the common stock interest coverage ratio (see the timesinterest earned measure in Chapter 7, Equation 7.7), fixed charge coverage isoften computed with EBITDA in the numerator, rather than EBIT. Since earn-ings before interest, taxes, depreciation, and amortization will normally bemore than EBIT, use of EBITDA will result in a higher coverage ratio—some-thing that should be taken into consideration when assessing this measure.Also, if you’re dealing with one of the newer debt-like preferreds, then you can drop the adjustment factor (0.65) in the denominator, because preferreddividends are treated just like interest expense in these cases. Doing so will, of course, lead to a higher fixed-charge coverage—the denominator will besmaller, so other things being equal, the fixed-charge coverage ratio will be higher.

Agency Ratings Standard & Poor’s has long rated the investment quality ofpreferred stocks, and since 1973, so has Moody’s. S&P uses basically the samerating system as it does for bonds; Moody’s uses a slightly different system.For both agencies, the greater the likelihood that the issuer will be able to pay

��Fixed charge coverage 5Earnings before interest and taxes (EBIT)

Interest expense 1Preferred dividends

0.65


fixed charge coveragea measure of how well a firm isable to cover its preferred stockdividends.


dividends promptly, the higher the rating. Much like bonds, thetop four ratings designate investment-grade (high-quality) pre-ferreds. Although preferreds come in a full range of agency rat-ings, most tend to fall in the medium-grade categories (a andbaa), or lower. Generally speaking, higher agency ratings reducethe market yield of an issue and increase its interest sensitivity.Agency ratings not only eliminate much of the need for funda-mental analysis, but also help investors get a handle on the yieldand potential price behavior of an issue.

Investment Strategies

There are several investment strategies that preferred stockholders can follow.Each is useful in meeting a different investment objective, and each offers a dif-ferent level of return and exposure to risk.

Looking for Yields This strategy represents perhaps the most popular use ofpreferred stocks and is ideally suited for serious long-term investors. High cur-rent income is the objective, and the procedure basically involves seeking outthose preferreds with the most attractive yields. While yield is necessarily a keyvariable, consideration is also given to such features as the quality of the issue,whether the dividends are cumulative, the existence of any call or sinking-fundprovisions, and, of course, whether the dividend qualifies for the new prefer-ential tax rate.

Certainty of income and safety are important in this strategy, becauseyields are attractive only as long as dividends are paid. Some investors neverbuy anything but the highest-quality preferreds. Others sacrifice quality inreturn for higher yields when the economy is strong and use higher-qualityissues only during periods of economic distress. Whenever you leave one of thetop four agency ratings, you should recognize the speculative position you areassuming. This is especially so with preferreds, since their dividends lack legalenforcement.

Like common shares, most preferreds pay dividends on a quarterly basis.Even so, some special breeds of preferred stocks offer not only attractive yieldsbut also monthly income. One of these is a type of hybrid security known as amonthly income preferred stock (MIPS, for short). However, as the Investingin Action box on pages 512 and 513 explains, although these securities dooffer attractive yields, they are a very unusual type of investment vehicle. Assuch, you should learn as much as you can about these, and other specialty,securities before investing in them.

Trading on Interest Rate Swings Rather than assuming a “safe” buy-and-hold position, the investor who trades on movements in interest rates adopts anaggressive short-term trading posture. This is done for one major reason: cap-ital gains. Of course, although a high level of return is possible with thisapproach, it comes with higher risk exposure. Because preferreds are fixed-income securities, the market behavior of investment-grade issues is closelylinked to movements in interest rates. If market interest rates are expected todecline substantially, attractive capital gains opportunities may be realized frompreferred stocks. Indeed, this is precisely what happened in the mid-1980s, andagain in the early 1990s (1991 through 1993) and in 2000–2003, when market


H O T L I N K SMoody’s Preferred stock ratings definitions are at:

www.aufhauser.net/securities/

FixedIncome/Ratings_Moody.htm

To learn more about credit ratings, visit FitchRatings Resource Library definitions at:

www.fitchratings.com/corporate/

fitchResources.cfm?detail=1

monthly income preferred stock (MIPS)a type of preferred stock thatoffers attractive tax provisions to the issuers, and attractivemonthly returns to investors.


interest rates dropped sharply. During such periods, it’s not uncommon to findpreferreds generating annual returns of 20% to 30%, or more.

As is probably clear by now, this strategy is identical to that used by bondinvestors. In fact, many of the same principles used with bonds apply to pre-ferred stocks. For example, it is important to select high-grade preferred stocks,because interest sensitivity is a key ingredient of this strategy. Moreover,margin trading is often used to magnify short-term holding period returns. Abasic difference is that the very high leverage rates of bonds are not availablewith preferreds, because they fall under the same, less generous margin require-ments as common stocks. The investment selection process is simplified some-what as well, because neither maturity nor the size of the annual preferreddividend (which is equivalent to a bond’s coupon) has any effect on the rate ofprice volatility. That is, a $2 preferred will appreciate just as much (in per-centage terms) as an $8 preferred for a given change in market yields.

Speculating on Turnarounds This speculative investment strategy can proveprofitable if you’re nimble enough to catch a trading opportunity before every-


In 1993 Goldman Sachs & Co., a leading invest-ment banking firm, invented monthly income

preferred stock, or MIPS, which looks like awin–win arrangement: Everyone seems to bene-fit. The issuer gets a tax deduction. The investorgets high monthly income, as well as the upsidepotential inherent in a stock. Here’s how theywork: XYZ Corporation creates a new entitycalled a limited-life company (LLC) that sellsMIPS to the public and lends the proceeds to the parent corporation. The parent pays interestto the LLC on the loan, which in turn is paid toMIPS holders in the form of monthly dividends.

From the issuer’s point of view, MIPS areattractive because the payments are taxdeductible, even though MIPS are not consid-ered straight debt and thus do not raise thecorporation’s debt ratio. That’s good, becausecredit rating agencies don’t like to see debtratios rise. MIPS are typically listed on the NewYork Stock Exchange, like many preferred stocks.Issuers have included such household names asAetna, GTE, and Corning. From the investor’spoint of view, MIPS offer higher yields than cer-tificates of deposit and money market funds.

They also provide higher yields than corporatebonds and conventional preferred stock. And thepayments are made monthly, whereas bondspay interest every 6 months and stocks paydividends quarterly.

The yield on conventional preferred stocktends to be driven down by corporate investors,who can deduct up to 70% of the dividendpayments from their corporate income tax.Individual investors don’t get that tax break, so conventional preferreds haven’t been mar-keted heavily to individuals. But MIPS havegotten their attention.

Not everyone thinks MIPS are great. The firstdrawback is that despite the term preferred intheir name, MIPS are quite low on the issuingcorporation’s list of obligations. If an issuer getsinto financial trouble, MIPS holders have tostand toward the end of the repayment line. Thesecond drawback is lack of call protection. Ifinterest rates fall, the issuer can redeem thesecurities at par without paying a penalty. Thatleaves the investor stuck with cash to reinvest atlower rates. The third drawback has to do withyour taxes. Corporations set up partnerships to

MIPS: There’s More to Them Than Higher Yields and Monthly Income

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one else does. The idea is to find preferred stocks whose dividends have goneinto arrears and whose rating has tumbled to one of the speculative categories.The price of the issue, of course, would be depressed to reflect the corporateproblems of the issuer. There is more to this strategy, however, than simplyfinding a speculative-grade preferred stock. The difficult part is to uncover aspeculative issue whose fortunes, for one reason or another, are about toundergo a substantial turnaround. This strategy requires a good deal of funda-mental analysis and is, in many respects, akin to investing in speculativecommon stock.

In essence, the investor is betting that the firm will undergo a turnaroundand will once again be able to service its preferred dividend obligations in aprompt and timely fashion. Such a bet obviously involves a fair amount ofrisk. Unfortunately, although the rewards from this kind of high-risk investingcan be substantial, they are somewhat limited. For example, if a turnaroundcandidate is expected to recover to a single-a rating, then its capital gainspotential would likely be limited to the approximate price level of othera-rated preferreds. This condition is depicted in Figure 12.2 (on page 514). As


issue these securities, which means that you geta K-1 instead of a Form 1099 at the end of theyear. In contrast to 1099s, which are sent out atthe end of January, most K-1s aren’t sent outuntil mid-March. And they’re a more compli-cated document. That means you’ll spend moretime on your taxes—or your accountant will,which means a higher bill to you. Indeed, a highaccounting fee could even wipe out the higheryields that MIPS offer. And, if these dividendsare actually interest payments, then they won’tqualify for the new preferential tax rates!

Don’t like MIPS? Then look at QUIPS, PRIDES,and PINES—some of the other types of hybridspecialty preferreds. Quarterly Income PreferredSecurities, or QUIPS, are structured like MIPSbut pay cumulative quarterly distributions.PRIDES, Preferred Redeemable IncreasedDividend Equity Securities, were developed byMerrill Lynch. They are similar to convertiblesecurities and are sold in units that comprise aninterest-bearing security, which provides stablecash flow, and a contract obligating the investorto purchase an underlying security at maturity.For example, in December 2001, Cinergy, Inc.,sold 5 million units of Income PRIDES. Each unitincluded a $50 preferred trust security and a

stock purchase contract. Holders received a 9.5%cash payment, paid quarterly, and were requiredto buy stock at a price within a range specifiedat the time of the unit purchase. PINES, PublicIncome Notes, are unsecured, unsubordinateddebentures sold in small share amounts, such as$25. They trade on the stock exchanges but alsopay fixed quarterly interest payments. Becausethey pay a fixed interest amount yet are tradedon stock exchanges, PINES represent a hybridbetween bonds and preferred stocks. SBCCommunications, Inc., has a 7% PINES issuethat trades on the NYSE, for example. In the 12-month period ending November 24, 2003,these shares traded between $25.21 and $27.68.

CRIT ICAL THINKING QUESTIONS Whymight investors be interested in buying MIPS?Do these securities have any noteworthy fea-tures? Are there any unusual risks associatedwith them? Explain.

Sources: Cinergy, Inc., 2001 Annual Report, downloadedfrom www.cinergy.com; Explanation of SecurityAcronyms, QuantumOnline.com, downloaded fromwww.quantumonline.com/SecurityAcronyms.htm,accessed November 24, 2003; and Investopedia.com,www.investopedia.com, accessed November 24, 2003.

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the figure shows, although price performance may be somewhat limited, it isstill substantial and can readily amount to holding period returns of 50% ormore. But in view of the substantial risks involved, such returns are certainlynot out of line.

Investing in Convertible Preferreds The investor following this strategyuses the conversion feature to go after speculative opportunities and the chancefor attractive returns. The use of convertible preferreds is based on their link tothe company’s common stock and on the belief that they will provide generousprice appreciation. Convertibles will be reviewed in detail below, but at thispoint, suffice it to say that as the price of the underlying common stock appre-ciates, so does the market price of a convertible preferred. This strategy canoffer handsome returns, but remember that investors who employ it are actu-ally speculating on the common stock dimension of the security. Therefore, it isthe equity position of the issue that should be subjected to scrutiny. The idea isto look for equity situations that hold considerable promise for appreciation,and then, rather than buying the common stock of the firm, purchase its con-vertible preferred instead.

I N R E V I E W

12.5 Describe how high-grade preferred stocks are priced in the market. What roledoes dividend yield play in the valuation of preferred stocks? Could you use thezero-growth dividend valuation model to value a preferred stock? Explain.

12.6 Discuss why dividend yield is critical in evaluating the investment merits ofhigh-grade preferred stocks during periods when market yields are expected todecline.

12.7 Identify several investment uses of preferred stocks. Would preferreds be suit-able for both conservative and aggressive investors? Explain.


FIGURE 12.2Price Pattern of a HypotheticalPreferred Turnaround CandidateAlthough a turnaround issueseeks the price level of otherpreferreds of comparable qualityand dividend payout, this levelalso acts as a type of price capand clearly limits capitalappreciation.

Time

Average price behavior

of investment-grade

preferreds

Price behavior

of a turnaround

issue

50

45

40

35

30

25

0

Sh

are

pri

ce (

$)

CO

NC

EP

TS


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