Adjusted preferred stock

What Is Adjusted Preferred Stock?

Adjusted preferred stock is a type of preferred stock whose dividend payments fluctuate based on a specified benchmark, typically an interest rate. This financial instrument belongs to the broader category of corporate finance, as it represents a method by which companies raise capital. Unlike traditional preferred stock that pays a fixed dividend, the dividend rate of adjusted preferred stock is periodically reset according to a predetermined formula, often tied to a benchmark interest rate such as the U.S. Treasury Bills rate. This variability aims to stabilize the market value of the preferred shares by allowing their payouts to adapt to prevailing economic conditions.

History and Origin

The concept of preferred stock itself dates back to the mid-19th century in the United States, with the Pennsylvania Railroad Company credited for issuing the first preferred shares. These early forms offered investors a more secure income stream and priority claim on assets compared to common stock.⁵ Over time, the features of preferred stock evolved to include various structures, such as convertibility and callability. The introduction of adjusted preferred stock emerged as a response to market demands for instruments that could mitigate interest rate risk. By linking the dividend rate to a variable benchmark, these securities were designed to offer greater price stability than fixed-rate preferred stock in fluctuating interest rate environments.

Key Takeaways

• Adjusted preferred stock features dividends that are reset periodically based on a benchmark interest rate.
• This mechanism helps to stabilize the market price of the stock by adapting its yield to current rates.
• It offers investors a degree of protection against rising interest rates by increasing dividend payouts.
• Issuers may use adjusted preferred stock to attract investors seeking income stability with some equity characteristics.
• Holders of adjusted preferred stock typically retain priority over common stockholders for dividend payments and in the event of liquidation.

Formula and Calculation

The dividend calculation for adjusted preferred stock is based on a specified benchmark rate and a pre-established formula. While the exact formula varies by issuance, a common approach involves adding a spread to the benchmark rate.

For example:

[
\text{Dividend Rate} = \text{Benchmark Rate} + \text{Predefined Spread}
]

The annual dividend payment per share would then be:

[
\text{Annual Dividend Payment} = \text{Par Value} \times \text{Dividend Rate}
]

Where:

• (\text{Benchmark Rate}) is the prevailing rate of an agreed-upon index (e.g., 3-month Treasury Bill rate).
• (\text{Predefined Spread}) is a fixed percentage added to the benchmark rate.
• (\text{Par Value}) is the face value of the preferred stock.

This dividend rate is adjusted on predetermined dates, often quarterly, ensuring that the payout reflects current market conditions and impacting the stock's overall valuation.

Interpreting the Adjusted Preferred Stock

Interpreting adjusted preferred stock involves understanding its hybrid nature, blending characteristics of both debt and equity. The primary feature to observe is how its dividend rate adjusts in response to changes in the underlying benchmark interest rate. When benchmark rates rise, the dividends paid on adjusted preferred stock typically increase, making the investment more attractive to income-focused investors. Conversely, if benchmark rates fall, the dividend payments will decrease.

This adjustment mechanism is designed to maintain the stock's market price stability, as the income stream adapts to reflect current yields. For investors, this means the net asset value (NAV) of the preferred stock tends to be less volatile than that of fixed-rate preferred stock in a changing interest rate environment. Understanding the specific terms, including any dividend caps or floors, is crucial for evaluating the potential income and price stability of a particular adjusted preferred stock issuance.

Hypothetical Example

Imagine Company ABC issues adjusted preferred stock with a par value of $100 and a dividend rate set at the 1-year U.S. Treasury rate plus 2%. Dividends are paid quarterly.

Scenario 1: Initial Issuance

• The 1-year U.S. Treasury rate is 3%.
• Adjusted Dividend Rate = 3% + 2% = 5%.
• Annual Dividend Per Share = $100 \times 5% = $5.
• Quarterly Dividend Per Share = $5 / 4 = $1.25.

Scenario 2: Six Months Later

• The 1-year U.S. Treasury rate increases to 4%.
• On the next dividend reset date, the Adjusted Dividend Rate adjusts to 4% + 2% = 6%.
• Annual Dividend Per Share = $100 \times 6% = $6.
• Quarterly Dividend Per Share = $6 / 4 = $1.50.

In this example, the dividend income for the holder of the adjusted preferred stock increases as market interest rates rise, demonstrating how the adjustable feature aims to mitigate the impact of rising rates on the investor's income stream. This contrasts with a fixed-rate preferred stock, where the dividend would remain constant regardless of interest rate movements, potentially leading to a decline in its market value if rates increase.

Practical Applications

Adjusted preferred stock serves various purposes within corporate finance and for investors. For companies, it offers a flexible way to structure their capital structure, providing a financing option that combines aspects of both equity financing and debt financing. It can be particularly attractive when a company seeks to raise capital without taking on additional debt or diluting the voting power of common shareholders. Issuers might prefer adjusted preferred stock over fixed-rate options to better manage their dividend costs in a volatile interest rate environment.

From an investor's perspective, adjusted preferred stock can be a valuable addition to a portfolio, offering a relatively stable income stream with dividend payments that adapt to prevailing interest rates. This makes them appealing to investors looking for consistent income and some protection against inflation. Furthermore, preferred stock, including adjusted preferred stock, can qualify as regulatory capital for financial institutions, making them a relevant instrument in the banking sector's capital planning. The Federal Reserve, for instance, provides guidance on how perpetual preferred stock can be counted towards a banking organization's capital requirements.⁴ During the 2008 financial crisis, the U.S. Treasury famously injected capital into banks like Bank of America through the purchase of preferred stock as part of bailout efforts, showcasing their role in systemic financial stability.³

Limitations and Criticisms

Despite their advantages, adjusted preferred stock instruments have limitations. One primary concern for investors is the potential for declining dividend income in a falling interest rate environment. While the adjustable feature aims to stabilize the stock's price, it can lead to reduced payouts if benchmark rates decrease significantly. Additionally, the complexity of the dividend adjustment formula and the specific terms (e.g., dividend caps and floors) can make it challenging for the average investor to fully understand and compare these securities.

From a company's perspective, issuing adjusted preferred stock still entails a dividend obligation that, while variable, generally has priority over common stock dividends. In periods of financial stress, these obligations could strain a company's liquidity. Accounting for preferred stock can also be complex, affecting how it is presented on the balance sheet and impacting financial ratios. Regulators, such as the Securities and Exchange Commission (SEC), have emphasized the importance of sound valuation and disclosure practices, particularly for illiquid or complex securities, to ensure transparency and prevent overvaluation.² Critics suggest that the hybrid nature of preferred stock can sometimes obscure its true risk profile, especially for non-sophisticated investors, highlighting the need for thorough due diligence.¹

Adjusted Preferred Stock vs. Callable Preferred Stock

Adjusted preferred stock and callable preferred stock are both types of preferred shares with distinct features. The primary difference lies in the mechanism of their "adjustment" or redemption.

While adjusted preferred stock's dividends float with market rates to maintain price stability, callable preferred stock grants the issuing company the right to repurchase the shares at a predetermined price after a specified date. This call feature allows the issuer to redeem the shares if market interest rates decline or if their financial position improves, effectively refinancing at a lower cost or reducing outstanding equity. The confusion between the two often arises because both types of preferred stock involve a degree of responsiveness to market conditions, but through different mechanisms benefiting either the investor (adjusted) or the issuer (callable).

FAQs

What is the main benefit of adjusted preferred stock for an investor?

The main benefit for an investor is that the dividend payments on adjusted preferred stock can increase when market interest rates rise, offering a degree of protection against inflation and providing a variable income stream.

Can adjusted preferred stock lose value?

Yes, like any security, adjusted preferred stock can lose market value. While the adjustable dividend aims to stabilize its price, factors such as the issuing company's financial health, changes in credit ratings, or broader market sentiment can still impact its trading price.

Are adjusted preferred dividends guaranteed?

Dividends on adjusted preferred stock are generally "preferred," meaning they must be paid before common stock dividends. However, they are not strictly guaranteed like interest on a bond. A company must have sufficient earnings to declare and pay dividends. If a company faces financial difficulties, dividend payments could be reduced or suspended.

How does adjusted preferred stock differ from a bond?

Adjusted preferred stock shares some characteristics with bonds, such as regular payments (dividends) and often no voting rights. However, preferred stock is an equity instrument, representing ownership in a company, whereas a bond is a debt instrument, representing a loan to the company. Preferred stock also typically has no maturity date and ranks below bonds in the event of a company's liquidation.