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 of Preferred 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 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 of Preferred 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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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.