What Is Fixed Rate Preferred Stock?
Fixed rate preferred stock is a type of preferred stock that pays a constant dividend rate over its lifetime. It is classified as a hybrid security within the broader category of equity securities, combining characteristics of both common stock and debt instruments. Unlike common stock, fixed rate preferred stock typically does not carry voting rights but offers a higher claim on a company's assets and earnings compared to common shares, particularly during liquidation. The "fixed rate" component means that the dividend payment, often expressed as a percentage of the par value, remains constant regardless of changes in market interest rates.
History and Origin
The concept of preferred stock, which underpins fixed rate preferred stock, emerged in the United States during the 19th century as corporations sought to raise capital. Early uses of this hybrid class of stock were particularly notable in the transportation industry, especially among railroad companies, which required significant funding for large-scale projects. Preferred stock provided a mechanism to attract investors by offering preferential rights, such as fixed dividends, compared to common shareholders. While initially governed by special legislation, the successful and continuous use of preferred stocks led to their regulation under general acts, standardizing their issuance and features.5
Key Takeaways
- Fixed rate preferred stock offers a consistent, predetermined dividend payment, providing a predictable income stream.
- These shares typically do not grant voting rights to holders but have priority over common stockholders for dividend payments and asset distribution upon liquidation.
- The fixed nature of dividends makes fixed rate preferred stock sensitive to changes in prevailing interest rates, with prices generally falling when rates rise.
- Companies may issue fixed rate preferred stock to raise capital without diluting common shareholder voting control or incurring the rigid obligations of debt.
- Understanding the specific terms, including call provisions and cumulative features, is crucial when evaluating fixed rate preferred stock.
Formula and Calculation
The value of a fixed rate preferred stock can be estimated using a simplified dividend discount model, treating it somewhat like a perpetuity, assuming the dividends are expected to continue indefinitely and are constant. The formula is:
Where:
- Annual Fixed Dividend is the total dividend payment per share per year. This is calculated as the par value multiplied by the fixed dividend rate.
- Required Rate of Return is the return an investor expects to receive for holding the preferred stock, considering its associated risks. This represents the investor's opportunity cost of capital.
For example, if a fixed rate preferred stock has a par value of $100 and pays a 5% fixed dividend, the annual fixed dividend would be ( $100 \times 0.05 = $5 ). If the required rate of return for an investor is 6%, the theoretical value of the preferred stock would be ( $5 / 0.06 = $83.33 ).
Interpreting the Fixed Rate Preferred Stock
Interpreting fixed rate preferred stock largely involves assessing the stability of its dividend income against its price fluctuations and the issuing company's financial health. Because the dividend is fixed, the stock's market price tends to move inversely with changes in overall market interest rates. When interest rates rise, the fixed dividend becomes less attractive relative to new fixed-income investments, causing the preferred stock's price to fall to achieve a competitive yield. Conversely, when interest rates fall, the fixed dividend becomes more appealing, leading to an increase in the preferred stock's price. Investors typically consider fixed rate preferred stock for its income generation rather than its potential for capital appreciation. The issuer's creditworthiness is also a significant factor, as it impacts the reliability of dividend payments and the likelihood of redemption at par.
Hypothetical Example
Consider "Horizon Corp. 6% Series A Fixed Rate Preferred Stock" with a par value of $25. This means Horizon Corp. commits to paying an annual dividend of 6% of $25, which is $1.50 per share ($25 * 0.06 = $1.50). These dividends are typically paid quarterly, so each quarter an investor would receive $0.375 per share ($1.50 / 4).
Imagine an investor, Sarah, buys 100 shares of this fixed rate preferred stock at its par value of $25 per share, for a total investment of $2,500. Every quarter, she would receive $37.50 in dividends (100 shares * $0.375/share). If general interest rates in the market later rise significantly, say, to a point where new preferred stock issuances offer a 7% yield, the market price of Sarah's existing Horizon Corp. 6% Series A preferred shares would likely decrease. This is because a new investor would demand a higher yield to compensate for holding a stock with a lower fixed dividend compared to what's available elsewhere. Conversely, if interest rates fell, the value of her fixed rate preferred stock would likely increase.
Practical Applications
Fixed rate preferred stock serves several key purposes for both issuers and investors in financial markets. For companies, issuing fixed rate preferred stock can be a way to raise capital without diluting the voting power of common stock holders, as these shares typically do not carry voting rights. It also provides a financing option that is less rigid than bonds since preferred dividends can sometimes be deferred (if non-cumulative) without triggering default, unlike bond interest payments. However, the U.S. Securities and Exchange Commission (SEC) has specific disclosure requirements for redeemable preferred stocks, highlighting the importance of transparent financial reporting for these securities.4 For instance, Bank of America has issued various series of fixed-rate preferred stock to manage its capital structure, such as its 7.25% Non-Cumulative Perpetual Convertible Preferred Stock, Series L.3
For investors, fixed rate preferred stock can be an attractive option for its predictable income stream, making it suitable for those seeking stable quarterly or semi-annual payments. It is often favored by institutional investors and income-focused individual investors looking for higher yield than traditional bonds while maintaining a higher claim on assets than common stock.2 These securities provide a middle ground between debt and equity, offering a blend of income stability and equity participation.
Limitations and Criticisms
While fixed rate preferred stock offers advantages, it also carries specific limitations and criticisms. A primary concern is their sensitivity to changes in interest rates. Because the dividend payment is fixed, when market interest rates rise, the price of existing fixed rate preferred stock tends to fall, as new issues offer more attractive yields. This exposes investors to interest rate risk. Conversely, when interest rates decline, callable fixed rate preferred stock can be redeemed by the issuer, forcing investors to reinvest their capital at lower prevailing rates, known as call risk.1
Another limitation is the lack of potential for significant capital appreciation compared to common stock, as their price is primarily driven by their fixed income stream rather than earnings growth. Additionally, while preferred stockholders have a higher claim than common stockholders during liquidation, they are still subordinate to bondholders and other creditors. Therefore, in the event of a company's financial distress, preferred stockholders may not recover their full investment. It is essential for investors to scrutinize the issuing company's financial statements and the specific terms of the fixed rate preferred stock.
Fixed Rate Preferred Stock vs. Adjustable-Rate Preferred Stock
The key distinction between fixed rate preferred stock and adjustable-rate preferred stock lies in how their dividends are determined. Fixed rate preferred stock, as discussed, pays a constant dividend payment that does not change over the life of the security. This predictability is a draw for income-focused investors who prefer a stable income stream. However, this fixed nature means their market price is particularly sensitive to fluctuations in interest rates: rising rates make the fixed dividend less attractive, pushing prices down, and vice versa.
In contrast, adjustable-rate preferred stock features a dividend rate that resets periodically, often tied to a benchmark interest rate such as SOFR (Secured Overnight Financing Rate) or a similar index. This floating dividend rate aims to reduce the interest rate risk for the investor, as the dividend income adjusts with market conditions. When benchmark rates rise, the dividend payment on adjustable-rate preferred stock increases, and when rates fall, the dividend decreases. This feature can make their market price less volatile than fixed rate preferred stock in changing interest rate environments, as the yield adjusts rather than the price bearing the full brunt of market shifts.
FAQs
What happens if a company cannot pay dividends on its fixed rate preferred stock?
If a company cannot pay dividends on its fixed rate preferred stock, the consequences depend on whether the stock is cumulative or non-cumulative. For cumulative preferred stock, any missed dividends accumulate and must be paid to preferred shareholders before any dividends can be paid to common stock holders. For non-cumulative preferred stock, missed dividends are generally not recovered. Most fixed rate preferred stocks are non-cumulative.
Do fixed rate preferred stocks have a maturity date?
Many fixed rate preferred stocks, particularly those issued by financial institutions, are perpetual, meaning they do not have a set maturity date. However, some may have a call feature, allowing the issuer to redeem the shares at a specified price and date. This is different from the fixed maturity date typically found with bonds.
How does a company redeem fixed rate preferred stock?
When a company decides to redeem fixed rate preferred stock, it typically repurchases the shares from investors at a predetermined price, usually their par value, plus any accrued and unpaid dividends if the stock is cumulative. This is often done when prevailing interest rates have fallen, allowing the company to issue new preferred stock or debt at a lower cost.
Are fixed rate preferred stocks considered safer than common stocks?
Generally, fixed rate preferred stocks are considered to have less risk than common stocks due to their priority in receiving dividends and their higher claim on assets during liquidation. However, they carry more risk than bonds because bondholders have the highest priority in the event of bankruptcy, and preferred stock dividends are not guaranteed in the same way bond interest payments are.