There are different types of preferred stocks that can be issued by companies and purchased by investors. These stocks are mainly issued by companies who do not want to dilute control but want to raise funds from investors. We shall look at the various types of preferred stocks hereafter but first, let us understand the meaning of preferred stock.
Preferred stocks meaning
Preferred stocks are kinds of stock that are referred to as hybrid security that combine the characteristics of bonds and common stock. The characteristic of bonds that they have is the fixed and regular dividend payments to their holders. The characteristic of common stock they have is the ownership stake in the issuing company and the potential for the share price to appreciate over time. These stocks are generally issued at the par value and the dividend payments that their holders receive are usually a percentage of this par value or a fixed rate which is usually predetermined in the stock’s prospectus.
Preferred stocks normally have very long maturity dates that last as long as thirty years or more. At maturity, the issuing company buys back the stocks from the stockholders and pays them back their initial investment. In a situation where the company that issued the preferred stocks liquidates, the preferred stockholders have a claim on the company’s assets that is inferior to that of bondholders but superior to that of holders of voting shares.
Preferred and common stock are the two stock types that make up the stockholders’ equity section in a company’s balance sheet. Unlike common stocks which generally give their holders the right to vote in the issuing company’s decision-making processes, preferred stocks are generally nonvoting which means that their holders have no say in the issuing company. Additionally, the capital gains on preferred stocks are limited since the stock price is closely related to the market interest rate and changes slowly compared to common stock which can change rapidly due to market forces of demand and supply.
Preferred stocks are also referred to as preferred, preference shares, or preferred shares.
See also: Different classes of stocks
Types of preferred stocks
- Adjustable rate preferred stock (ARPS)
- Monthly income preferred stock (MIPS)
Adjustable rate preferred stock (ARPS)
The adjustable rate preferred stock is a type of preferred whose dividend payment to investors is regularly modified based on changes in a benchmark rate; one such benchmark is that used for the treasury bills. The particular benchmark rate that would be used for the dividend payment adjustments to an ARPS is usually predetermined when the stocks are issued. These modifications are generally made quarterly and the dividend payment generally has a cap value that cannot be exceeded. This is done in order to ensure that the issuing company does not become obligated to pay an extremely large sum as dividends to the holders of ARPS. Adjustable rate preferred stocks tend to have a stable market value because the built-in dividend rate adjustments insulate them from changes in interest rates for which other securities may be liable.
The consistent dividend payments and the stable market value of ARPS make it an advantageous investment and especially attract investors that are seeking stable returns and protection for their initial capital investment. However, since the dividend payment is dependent on the benchmark that is used to adjust it, the stockholders will receive a lower dividend when the benchmark interest rate falls.
Convertible preferred stock
Convertible preferred stock is a type of preferred that confers on its owner, the ability to convert the stocks to a specified number of common stocks of the issuing company at or after a preset date. Due to this ability to get converted, the stock value is partially dependent on the market value of the common shares. These stocks are also referred to as convertibles or convertible preferreds or convertible preferred shares.
The number of common stocks that the convertible preferred stockholder will receive is usually indicated in the stock prospectus. For example, the conversion rate could be 1:3, which means that for every convertible preferred owned, the holder gets three common stocks at conversion. The conversion of convertibles is generally initiated by the stockholder, however, in some instances, the stocks get converted automatically after a predetermined date or at the discretion of the issuing company.
Convertibles are mostly issued by startups who are not ready for an immediate involvement of investors in the issuing company but are willing to take that own after the years when the convertibles can be converted to common stock. Investors also purchase these stocks to invest in startups that they feel have good growth potential.
Cumulative preferred stock
Cumulative preferred stock is also referred to as cumulative preference shares. All preferred stock enjoy a fixed dividend payment but in addition to that, this type of preferred has a special feature that mandates the issuing company to pay the stockholders dividends in arrears. Hence, in a situation where the issuing company is unable to pay dividends either due to financial challenges or having reinvested all profits, they will have to pay the cumulative preferred stockholders all previously unpaid dividends. As such, the dividend payments of the stockholders are said to be cumulative.
When the payments of dividends are done in arrears, all cumulative stockholder’s arrears have to be completely paid up first and holders of common stock will only get paid if there are still leftover dividends. If nothing is left over, they do not get paid. The payment of cumulative preferred dividends is usually quarterly or annually.
Exchangeable preferred stock
The exchangeable preferred stock as the name implies is a type of preferred that can be exchanged for another type of security that is issued by the company. Most commonly, these stocks are exchanged for the bonds of the same company hence converting them from a mixed security instrument to s single security instrument. The conversion of the exchangeable preferred stock to bonds is usually done at a predetermined rate such as 1:2 where the stockholder gets one bond for every 2 exchangeable preferred stocks they own.
Monthly income preferred stock (MIPS)
The monthly income preferred stock is generally issued by subsidiaries in order to raise funds for their parent company. Most of these subsidiaries are created specifically for this purpose and are therefore referred to as a special purpose entity (SPE). The parent company’s interest payments to the SPE are tax deductible as interest and the SPE uses it to pay the MIPS stockholder’s dividends. The dividend payments are generally made every month just as the name of this particular type of preferred stock implies.
Noncumulative preferred stock
Unlike the earlier discussed cumulative preferred stockholders who get paid dividends in arrears, noncumulative preferred stockholders do not get paid dividends in arrears meaning that their dividends do not accumulate. If for whatsoever reasons dividends are unpaid, the company is not obligated to pay the stockholders those missed dividends, instead, they get paid whenever dividend payments resume, and the unpaid dividends are automatically forfeited.
Noncumulative preferred stocks are also referred to as noncumulative preferred or noncumulative preference shares.
Nonparticipating preferred stock
Nonparticipating preferred stock is a type of preferred that have a cap on the number of distributions that the stockholders are entitled to whenever dividends are paid. The particular amount of dividend they are entitled to, is usually predetermined in the stock certificate and is generally not changeable. Additionally, like all other types of preferreds, holders of this stock type do not have voting rights in the issuing company.
Participating preferred stock
Participating preferred stock is a type of preferred stock that enables its holders to benefit from fixed and regular dividend payments just like bondholders and additional distributions like common stockholders. If for instance, the issuing company declares dividends, the holders of these stocks get paid the prefixed dividend rate as well as an additional dividend that is equivalent to the dividend amount paid to common stockholders. Thus, they are said to have participated in the additional distributions that were paid by the company. The additional distribution is paid whenever the issuing company has realized excess profits and has declared larger distributions than they normally do.
Participating preferred stocks are also referred to as participating preference shares or participating preference stock
Perpetual preferred stock
A perpetual preferred stock generally has no maturity date. This means that there is no date on or after which the stock gets repurchased by the issuing company and the initial investment is paid back to the investor. Hence, for as long as the company that issued the stock is in existence, the stockholder enjoys regular fixed dividend payments from the issuing company. As a result of this feature of perpetual existence, investors purchase these preferred stock types to serve mainly as a form of regular income through the dividend payments that they are entitled to receive. It is also considered a low-risk investment because of its perpetuity.
Preference preferred stock
When it comes to dividend payments, the preference preferred stockholders get paid first ahead of other types of preferred stocks with only the prior preferred stock being ahead of them. As such, the ranking of dividend payments usually starts from bondholders to prior preferred stockholders to preference preferred stockholders to other types of preferred stocks to common stockholders.
Prior preferred stock
The prior preferred stockholders have a higher claim to dividends and assets in liquidation than any other type of preferred stock. This means that the holders of this stock get paid first when distributions have been declared and also get the first claim to assets if the issuing company liquidates.
Putable preferred stock
The putable preferred stock gives its holder the option of selling back the stock to the issuing company on or after a preset date. The issuing company normally includes this option known as a put option in the stock terms. This put option generally places a minimum price at which the stocks will be sold back to the issuing company if the stockholder decides to use their option of selling back to the company.
See also: Call options
Video on types of preferred stocks
We have discussed the different types of preferred stocks and seen what each preferred stock type means. Since preferred stocks are not as commonly and frequently issued as common stock, it is necessary that investors who choose to invest in any type of preferred stock understand the particular type they are purchasing and the terms of the preferred as stipulated in its prospectus.