Adjustable Preferred Stock Pros & Cons

Adjustable preferred stock shares most of the pros and cons of its nonadjustable brethren, plus a few unique features that influence its appeal. Corporations must pay all dividends on preferred stock before paying common stock dividends. If a company liquidates, the proceeds flow to holders of bonds, preferred stock and common stock, in that order. Adjustable preferred shares have dividends that periodically reset to match prevailing interest rates.

Double-Edged Features

The unique features of adjustable preferred stock can be pros or cons, depending on interest rates. APS dividend rates tie to a specific reference interest rate or index. When the reference rate falls, so does the APS dividend rate. This is a double con, since the investor receives smaller dividends and the price of the stock shows little change, whereas fixed-rate preferred stock prices rise when interest rates decline. APS prices remain stable through most interest rate changes, though the price may be lower than the original issue price, depending on which reference rate is chosen. When interest rates rise, APS dividends increase -- a definite plus.

Collars

A collar consists of a cap and floor on dividend yields. Floors are good but caps are bad. A floor is the minimum dividend yield the APS will pay, even if interest rates fall below the floor. A cap puts a limit on the maximum dividend yield. Investors like floors; caps, not so much. When interest rates operate outside the collar range, APS acts like fixed-rate preferred stock. Corporations are likely to call, or forcibly redeem, floored callable shares and issue new ones with a lower floor, or no floor at all. In general, investors dislike callable shares because issuers redeem shares when it suits the corporation’s interests, not necessarily those of the shareholders.

Dividend Reset Spread

Some APS is indexed to Treasury debt. The yield curve of Treasury debt plots time until maturity against yield. For example, the 30-year bond might yield 4 percent when the one-year bill yields 1 percent. Treasury-linked APS often uses a dividend reset spread to determine the current dividend yield. The reset spread is the highest yield among three points on the Treasury yield curve, reflecting short-, intermediate- and long-term interest rates. The dividend reset spread is a definite plus, because it protects against shifts in the yield curve that favor one maturity over another.

Auction-Rate Preferred Stock

One subspecies of APS uses periodic auctions to reset dividend yield. The auction participants are current and potential shareholders. The auction ensures that the APS dividend yield reflect the current requirements of investors. The benefit of auction-rate preferred stock is that the stock's price seldom falls below par, which is the face value of the shares.

Remarketed Preferred Stock

Remarketed preferred stock is another variety of APS. A remarketing agent periodically adjusts the dividend rates on these securities to maintain prices at par. Reset periods normally last either seven or 49 days. Shareholders tender these shares to the remarketing agent at a specified liquidation price. The agent auctions, or remarkets, them at yields that produce the original offering price. Another form of remarketed preferred stock -- share-adjusted preferred -- gives the remarketing agent the ability to set the length of the reset period. Remarketed preferred stock benefits shareholders by ensuring they can auction their shares at the liquidation price, reducing or eliminating capital losses.

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About the Author

Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.

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