Adjustable rate preferred stock arps

What Is Adjustable-Rate Preferred Stock (ARPS)?

Adjustable-rate preferred stock (ARPS) is a type of preferred stock where the dividends paid to shareholders are not fixed but instead periodically adjust based on a specified benchmark interest rate. These securities belong to the broader category of financial securities, representing a hybrid instrument that combines features of both equity and fixed income. Unlike traditional preferred shares with static dividend payments, ARPS offers a fluctuating dividend that typically resets quarterly, often tied to rates like those of Treasury bills. This design aims to provide investors with a more stable market value by insulating the share price from significant swings due to changes in prevailing interest rates.,¹⁴

History and Origin

The concept of adjustable-rate preferred stock emerged as an innovative response to fluctuating economic conditions, particularly during periods of significant interest rate volatility. These securities gained notable traction in the United States during the 1980s. At that time, the Federal Reserve aggressively increased the federal funds rate to combat high inflation, with rates reaching historic highs, sometimes exceeding 19% in the early 1980s.¹³ This era of rapidly changing rates made traditional fixed-income investments, including fixed-rate preferred stock, less appealing, as their market values would decline sharply when new, higher-yielding securities became available. ARPS was designed to mitigate this interest rate risk for investors by offering dividends that would adjust upward with rising rates, thereby maintaining the attractiveness of the investment.

More recently, the global financial landscape has seen another significant event impacting floating-rate instruments: the cessation of the London Interbank Offered Rate (LIBOR). For decades, LIBOR served as a primary benchmark for many adjustable-rate securities worldwide. However, due to concerns about its integrity and representativeness, regulators mandated its discontinuation. Financial institutions, including those with outstanding ARPS linked to LIBOR, embarked on a complex transition to alternative reference rates, most notably the Secured Overnight Financing Rate (SOFR), with most U.S. dollar LIBOR settings ceasing publication after June 30, 2023.¹²,¹¹

Key Takeaways

• Adjustable-rate preferred stock (ARPS) pays dividends that reset periodically based on a benchmark interest rate.
• ARPS aims to provide more stable market values compared to fixed-rate preferred stock in changing interest rate environments.
• Dividends on ARPS are typically subject to "collars," meaning there are predetermined caps (maximums) and floors (minimums) on the dividend yield.
• Investors seeking income and a degree of capital preservation may find ARPS appealing, especially when anticipating rising interest rates.
• ARPS holders generally have a higher claim on a company's assets and earnings in liquidation than common stock shareholders.

Formula and Calculation

The calculation of the dividend for adjustable-rate preferred stock involves the benchmark rate, a potential spread, and the par value of the share. While the exact formula can vary slightly depending on the terms set by the issuer, a common representation of the annual dividend rate is:

$\text{Annual Dividend Rate} = \text{Benchmark Rate} + \text{Spread}$

And the periodic dividend payment is:

$\text{Periodic Dividend Payment} = \text{Par Value} \times \left( \frac{\text{Annual Dividend Rate}}{\text{Number of Payments per Year}} \right)$

Where:

• Benchmark Rate: The reference interest rate (e.g., Treasury bill rate, SOFR). This rate is dynamic and changes based on market conditions.
• Spread: An additional percentage point or basis point added to the benchmark rate. This spread is typically fixed at the time of issuance and compensates investors for the issuer's credit risk above the benchmark.
• Par Value: The stated face value of the preferred stock, on which the dividend percentage is calculated.
• Number of Payments per Year: The frequency of dividend payments, typically quarterly (4).

For example, if an ARPS has a par value of $25, a benchmark rate of 4%, and a spread of 1.5%, its annual dividend rate would be 5.5%. If dividends are paid quarterly, each payment would be $25 * (0.055 / 4) = $0.34375. It is important to note that these calculations are often subject to pre-defined collars, which are limits (caps and floors) on how high or low the dividend rate can go.¹⁰

Interpreting Adjustable-Rate Preferred Stock

Interpreting adjustable-rate preferred stock involves understanding its unique dividend mechanism and how it influences the security's performance in different market conditions. The key to interpreting ARPS lies in recognizing that its variable dividend is designed to keep its market price relatively stable by adjusting its yield to current financial markets rates. For instance, when benchmark rates rise, the ARPS dividend rate also increases, making the existing shares more attractive and thus helping to maintain their market value. Conversely, when benchmark rates fall, the dividend rate decreases, which helps to prevent a significant appreciation in the share price that would otherwise occur with a fixed-rate security.

Investors evaluate ARPS by looking at the specific benchmark it tracks, the spread offered, and the presence and levels of any dividend caps or floors. A higher spread indicates a greater premium over the benchmark, potentially reflecting higher perceived risk of the issuer or a more attractive offering. The collars are particularly critical: a low floor protects income during periods of declining interest rates, while a high cap limits potential upside when rates are soaring. Understanding these features allows investors to assess how ARPS will perform relative to their income expectations and overall investment portfolio strategy.

Hypothetical Example

Consider an investor, Sarah, who purchased 100 shares of ARPS issued by Company A. Each share has a par value of $50. The terms of the ARPS state that the dividend rate will reset quarterly based on the 3-month Treasury bill rate plus a spread of 2.0%, with a floor of 3.0% and a cap of 7.0%.

Scenario 1: Rising Interest Rates
In the first quarter, the 3-month Treasury bill rate is 2.5%.

• Annual Dividend Rate = 2.5% (Benchmark) + 2.0% (Spread) = 4.5%
• Since 4.5% is between the 3.0% floor and 7.0% cap, the dividend rate applies as calculated.
• Quarterly Dividend Payment per share = $50 * (4.5% / 4) = $0.5625
• Sarah's total quarterly dividend = 100 shares * $0.5625 = $56.25

In the second quarter, the 3-month Treasury bill rate rises to 5.5%.

• Annual Dividend Rate = 5.5% (Benchmark) + 2.0% (Spread) = 7.5%
• However, the dividend rate is capped at 7.0%.
• Quarterly Dividend Payment per share = $50 * (7.0% / 4) = $0.875
• Sarah's total quarterly dividend = 100 shares * $0.875 = $87.50

Scenario 2: Falling Interest Rates
Later, the 3-month Treasury bill rate falls to 0.5%.

• Annual Dividend Rate = 0.5% (Benchmark) + 2.0% (Spread) = 2.5%
• However, the dividend rate is floored at 3.0%.
• Quarterly Dividend Payment per share = $50 * (3.0% / 4) = $0.375
• Sarah's total quarterly dividend = 100 shares * $0.375 = $37.50

This example illustrates how the adjustable nature of ARPS, along with its collars, influences the income an investor receives, providing a degree of predictability within a changing interest rate environment.

Practical Applications

Adjustable-rate preferred stock serves several practical applications for both issuers and investors within financial markets. For corporations, issuing ARPS can be an attractive way to raise capital. It provides flexibility in managing interest expense, as dividend payments can decrease if benchmark rates fall, reducing the cost of financing for the issuer. This adaptability can be particularly beneficial for companies looking to manage their exposure to fluctuating monetary policy.

From an investor's perspective, ARPS can be a valuable tool for income generation and portfolio diversification. They are often favored by conservative investors who prioritize consistent income and capital preservation. The adjusting dividend rate provides a potential hedge against inflation in a rising interest rate environment, as the dividend income received by the investor can increase, helping to maintain purchasing power. Conversely, in a falling rate environment, the dividend will adjust downwards, but the price stability of ARPS helps protect the capital invested, which differentiates them from fixed-rate preferred stock.⁹,⁸ The benchmark for these dividends is frequently tied to widely recognized rates published by authoritative bodies, such as the daily Selected Interest Rates (H.15) released by the Federal Reserve Board.⁷

Limitations and Criticisms

Despite their advantages, adjustable-rate preferred stocks come with certain limitations and criticisms that investors should consider. One significant drawback is the potential for reduced income in a declining interest rate environment. While the dividend floor provides a minimum payout, if benchmark rates fall significantly and remain below the floored rate, the investor's income will be capped at that minimum, potentially leading to lower returns than initially expected. This is the inverse of the benefit they offer in rising rate environments.,⁶

Another concern can be liquidity risk. Although ARPS are typically publicly traded, their market may not always be as liquid as those for common stocks or even traditional fixed-rate preferred stocks. This can lead to wider bid-ask spreads, making it more challenging for investors to buy or sell shares at their desired price without impacting the market price.⁵ Furthermore, like all preferred stock, ARPS dividends are not a legal obligation for the issuing company. If a company faces financial distress, it may choose to skip or suspend dividend payments. If the ARPS is non-cumulative preferred stock, those missed dividends are never recovered by the investor, posing a considerable risk to income-focused shareholders.⁴ Additionally, while the adjusting dividend helps stabilize the price, ARPS can still be subject to call risk, where the issuer repurchases the shares, often when interest rates have fallen, allowing them to refinance at a lower cost.

Adjustable-Rate Preferred Stock vs. Fixed-Rate Preferred Stock

The primary distinction between adjustable-rate preferred stock (ARPS) and fixed-rate preferred stock lies in how their dividend payments are determined and, consequently, how their market values react to changes in interest rates.

The fundamental confusion often arises because both are types of preferred stock that offer dividends. However, their response to changing interest rates is diametrically opposed in terms of market value. Fixed-rate preferred stock behaves much like a long-term bond; when interest rates rise, the present value of its fixed future dividends decreases, causing its market price to fall. Conversely, if rates fall, its price rises. ARPS, by adjusting its dividend, attempts to maintain its yield in line with current market rates, thereby dampening the volatility of its market price.,³,

FAQs

Q1: How does an ARPS dividend typically reset?
A1: The dividend on an adjustable-rate preferred stock usually resets on a predetermined date, often quarterly. The new dividend rate is calculated based on a specified benchmark interest rate (like the 3-month Treasury bill rate or SOFR) plus a fixed spread, subject to any pre-defined caps and floors.²

Q2: What are "collars" in relation to ARPS?
A2: Collars refer to the upper and lower limits (caps and floors) placed on the dividend yield of adjustable-rate preferred stock. A cap is the maximum dividend rate the investor can receive, regardless of how high the benchmark rate goes. A floor is the minimum dividend rate, ensuring a certain level of income even if the benchmark rate falls very low.¹

Q3: Is adjustable-rate preferred stock suitable for all investors?
A3: ARPS can be suitable for investors seeking stable income and some protection against interest rate fluctuations. However, they may not be ideal for investors prioritizing significant capital appreciation, as their design emphasizes price stability rather than growth. As with any investment, it is important to consider individual financial goals and risk tolerance.

Q4: Do ARPS offer voting rights?
A4: Generally, preferred stock, including ARPS, does not carry voting rights in corporate matters, unlike common stock. However, some preferred issues may grant voting rights if the company defaults on dividend payments for a specified period.

Q5: What happens to ARPS if the issuing company experiences financial difficulties?
A5: In cases of financial distress or liquidation, preferred stockholders, including ARPS holders, have a higher claim on the company's assets and earnings than common stockholders. However, they are subordinate to all creditors (bondholders, banks, etc.). If the company struggles, it may suspend dividend payments. For non-cumulative preferred stock, any missed dividends are not recoverable.