Characteristics of preferred stock

Multiple Classes of Preferred Stock

Most companies issue one class of common stock, but it is quite common to see companies with more than one series of preferred stock. Table 3–1 lists some of the different preferred stock issues of Citigroup, Inc. (listed on the New York Stock Exchange).

Each class of preferred stock has different features. For example, Citigroup’s preferred F series pays a dividend of $3.18 per share with a yield of 6.3 percent at a closing price of $50.25 per share and was down $0.25 from the preceding day’s closing price. Citigroup has several cumulative preferred stock issues, which give holders the right to receive all missed dividend payments before common shareholders are paid. Convertible preferred stock can be converted, by holders, into a fixed number of shares of common stock of the underlying company. A call provision gives the issuing company the right to call the preferred stock at a specific price (normally a premium over its par value). These issues also might be differentiated in their priority status with regard to claims on assets in the event of bankruptcy.

Claims on Income and Assets

Preferred stock has a preference over common stock with regard to claims on both income and assets. Companies are required to pay dividends on preferred stock before they pay dividends to common stockholders. In the event of bankruptcy, preferred stockholders’ claims are settled before the claims of common shareholders. This makes preferred stock less risky than common stock but more risky than bonds because bondholders have priority in claims to income and assets over preferred stockholders. Companies must pay the interest on their debt, and in the event of a default, bondholders can force the defaulting corporation into bankruptcy, whereas dividends on preferred stock (and common stock) are declared only at the discretion of the board of directors. In the case of multiple classes of preferred stock, the different issues are prioritized in their claims to income and assets.

Cumulative Dividends

Most preferred stock issues carry a cumulative feature, which is a provision requiring a company to pay any preferred dividends that have not been paid in full before the company can pay dividends to its common stockholders. In other words, if the company fails to pay dividends to its cumulative preferred stockholders, it will have to pay all the missed dividends before the company can pay any dividends to its common shareholders. A company that fails to pay its dividends is said to be in arrears, which is defined as having outstanding preferred dividends that have not been paid on a cumulative preferred stock issue. Before the company can pay dividends to its common stockholders, it would have to pay the dividends in arrears to its cumulative preferred stockholders first. This cumulative feature protects the rights of preferred stockholders. A preferred issue that does not have a cumulative feature is called a noncumulative preferred stock. Dividends on such stock do not accumulate if they are not paid.

Convertible Feature

Some preferred stock issues have a convertible feature that allows holders to exchange their preferred stock for common shares. The conditions and terms of the conversion are set when the preferred stock is issued. The terms include the conversion ratio, which is the number of common shares the preferred stockholder will get for each preferred share exchanged, and the conversion price of the common stock.

For example, Chesapeake Energy Corporation issued a mandatory convertible preferred stock issue that will automatically convert on June 15, 2009, into a range of Chesapeake’s common stock (no fewer than 7.1715 shares of Chesapeake’s common stock and no more than 8.6059 shares depending on the then market price of Chesapeake’s common stock). If the price of Chesapeake’s common stock rises above the conversion price before June 15, 2009, holders can convert at their option.

The decision to exercise the conversion option depends on three factors:
* The market price of the common stock. It must be greater than the conversion price for the holder to share in capital gains.
* The amount of the preferred dividend.
* The amount of the common dividend.

The conversion feature provides the investor with the possibility of sharing in the capital gains through the appreciation of the common stock, as well as the relative safety of receiving the preferred dividends before conversion. If the preferred dividend is much greater than the common dividend, holders would weigh this into the amount of the appreciation as to whether to hold the preferred stock or convert to common stock.

Call Provision

A preferred stock issue with a call provision entitles the issuing company to repurchase the stock at its option from outstanding preferred stockholders. The call price generally is more than the preferred stock’s par value.

The call provision is advantageous to the issuing company and not to the holder of the preferred stock. When market rates of interest decline significantly below the dividend yield of the preferred issue, companies are more likely to exercise the call provision by retiring the issue and replacing it with a new preferred stock issue with a lower dividend yield. Citigroup redeemed for cash all the outstanding shares of its 8.4 cumulative preferred stock series K at a redemption price of $25 per share plus accrued dividends in October 2001. In January 2003, Citigroup called in its adjustable-rate cumulative preferred stock series Q and series R for a cash price of $25 per share plus accrued dividends.

When a preferred issue is called, the savings to the issuing company represents a loss of income to preferred stockholders. Thus not only do preferred stockholders suffer a loss of income when their high-dividend-rate preferred stock issues are called in, but the call provision also acts as a ceiling limit on the price appreciation of the preferred stock. When interest rates decline, there is an upward push on the price of high-dividend-rate preferred stock issues, but the price of the preferred stock will not rise above the call price. For example, if a preferred stock issue has a call price of $55, potential buyers of the preferred stock would be unlikely to pay more than this amount when interest rates decline significantly. This is so because investors who pay more than this ceiling price would lose money if the issue were called.

To entice investors to buy preferred stock issues during periods of high interest rates, companies include a call protection feature. This prevents the company from calling the issue for a period of time, generally five years, but this varies. After the call protection period, the issue is callable at the stated call price per share.

Participating or Nonparticipating

Participating preferred issues allow holders to receive additional dividends (over and above regular dividends) if they are declared by the board of directors. These additional dividends generally are less than the extra amounts paid to common shareholders. The majority of preferred stocks are nonparticipating.

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