Preferred Stocks

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Preferred Stocks Convertibles

• Topic 8
• I. Preferred Stocks

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A. Characteristics

• 1. Hybrid Securities
• a. Pay Dividends CS
• b. Equity Ownership CS
• c. Prior Claim Bond
• d. Fixed Dividends Bond

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A. Characteristics (continued)

• 2. Advantages / Disadvantages
• a. High Current Income
• b. Safety
• c. Low Unit Cost (10-25/Share)
• d. Inflation -- not a good hedge
• e. Lacks capital gain potential

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A. Characteristics (continued)

• 3. Sources of Value
• a. Dividend Yield
• P D / K
• D Dividend
• K Required Return

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B. Usual Features ofPreferred Stock

• 1. Voting
• Usually nonvoting but does have contingent voting
  rights. This is the right to elect some of the
  directors.
• Usually have the right to vote for approval on
  the issuance of additional Preferred Stock.
• 2. Maturity and Call
• Typically Preferred Stock has no maturity date
  (like C/S).
• The typical Preferred is callable.

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B. Usual Features ofPreferred Stock (continued)

• 3. Sinking Fund
• 40 of Preferred issues have this agreement,
  usually found in public utility Preferred
• 4. Dividends
• Cumulative VS Noncumulative
• 5. Convertibility
• Preferred is typically nonconvertible
• 1/3 of Preferred are convertible

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C. Yields

• 1. Compared with Bonds, Preferred are
• typically higher. Why?
• 2. Pattern
• Similar to Bonds
• 3. Yields have tended to be relatively unstable.
  This suggests a higher degree of risk.

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D. Analysis of Preferred Stock

• 1. Assets/Share
• Example
• Assume TA 110 TD 50
• 1 million Preferred Shares
• with 10 par
• The Net Asset/Share would be
• 60 million 60/Share 1
  million shares
• This would cover Par 6 x

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D. Analysis of Preferred Stock (continued)

• 2. Preferred Stock Ratings
• SP Rating AAA to C

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E. Preferred Stock as an Investment

• 1. Better suited for the Institution
• 2. Does not share in earnings
• 3. Does not have the security of Bonds,
• more volatile
• 4. Only becomes attractive when the yield is
  greater than Bonds

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Investing in Preferreds

• Most new-issue preferreds come with five year
  call protection, meaning the issuing corporation
  cannot call your preferred away from you for a
  full five years. After five years, its open
  season. If interest rates have declined and the
  price of preferreds has risen, you can expect a
  call. Issuing corporations will want to replace
  older, higher-yielding preferreds with new
  lower-yielding preferreds. During the five year
  period, the typical preferred will go up in value
  around the third year and then begin to decline.
  Therefore, in an environment of stable or
  decreasing interest rates, you will always get
  this peak and roll process.

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Investing in Preferreds

• The Peak and Roll of Preferreds Preferreds
  today promise 8 to 9. These are NYSE listed
  blue-chip securities. In order to cash in on
  preferreds, you need to understand the concept of
  peak and roll. Lets say that over three years
  of a preferreds existence, its price has risen
  to 27/share from its original offering price of
  25/share. The price of the preferred has risen
  because interest rates have declined. If the
  preferred is callable at five years, at some
  point between year three and year five, the price
  of the preferred will peak and begin to roll down
  back toward 25. Do not hang around for the
  complete peak and roll. When the stock hits a
  peak sell it and buy a new five year preferred.
  Your return is then 9 2.6 from the 2.

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Preferred Stocks Convertibles

• Topic 8
• II. Convertible Securities

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A. Characteristics

• 1. Hybrid possessing the features and
  performance qualities of both fixed income and
  equity securities
• 2. Should be viewed primarily as a form of
  equity
• 3. Provide the Equity Kicker
• 4. A Deferred Equity

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B. Convertible Bonds

• 1. Issued as Debentures
• 2. Over time, may be converted into a certain
  number of shares
• 3. Normally Freely Callable which may lead to
  Forced Conversion

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B. Convertible Bonds (continued)

• 4. Options at forced conversion
• Convert to shares
• Redeem the Bond for cash at the stipulated call
  price
• 5. Conversion Privilege
• Stipulates the conditions and nature of the
  conversion
• Initial waiting period of 6 months to 2 years
• Conversion period may have a limited life

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B. Convertible Bonds (continued)

• 6. Conversion Ratio
• Number of common shares which the Bond may be
  converted into
• Example A Ratio of 20 states that a 1000 Bond
  may be converted into 20 shares of the Common
• Implied conversion price is 50/Share
• Ratios are normally fixed but can be variable
• Ratios are adjusted for stock splits

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C. Sources of Value of Convertibles

• 1. Convertible Securities trade like a Common
  Stock. They derive value from the Common Stock.
• Example Assume a Convertible has a ratio of 20
  and the Stock sells for 45. If the conversion
  price is 50 (1000/20), then for every point the
  stock goes up or down the Convertible Security
  will move by 20x.
• Hence, Price of Convertible Security in example
  is 45 20 900

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D. Risk

• 1. Risk is a function of the issues fixed
  income and equity characteristics.
• 2. Fixed income nature defines its floor price.
• 3. Equity nature defines its ceiling price.