Redeemable preferred stock

What Is Redeemable Preferred Stock?

Redeemable preferred stock, also known as callable preferred stock, is a type of preferred stock that grants the issuing company the right, but not the obligation, to repurchase the shares from investors at a predetermined price after a specified date. This feature provides issuers with flexibility in managing their capital structure, especially in response to changing market conditions. Within the realm of equity securities, redeemable preferred stock combines characteristics of both debt and equity, often referred to as a hybrid security.³³, ³⁴, ³⁵

Companies typically issue redeemable preferred stock to raise capital. Holders of preferred stock receive fixed dividend payments before common stockholders and have a priority claim on company assets in the event of liquidation.³² The redeemable aspect means the company can buy back the stock, often at a premium, if it becomes advantageous, such as when interest rates decline, allowing them to issue new preferred shares at a lower dividend rate.³⁰, ³¹

History and Origin

The concept of preferred stock emerged in the mid-19th century in the United States, with the Pennsylvania Railroad Company issuing the first preferred shares. These shares were designed to offer investors higher dividend payouts and a priority claim on assets during bankruptcy, providing a more secure investment than common equity.²⁹ By the early 20th century, preferred stock gained popularity as large public utilities and transportation companies utilized them to raise capital.²⁸

The "callable" or "redeemable" feature, allowing issuers to repurchase the stock, developed as companies sought greater flexibility in their financing. This provision became particularly useful for managing the cost of capital. For instance, if a company issued preferred stock with a 7% dividend rate and market rates later dropped to 4%, the company could call back the existing shares and reissue new ones at the lower rate, thereby reducing its dividend payments.²⁷ Financial institutions are significant issuers of preferred stock, and the asset class has experienced various market behaviors over time, including periods of volatility during economic downturns, such as the 2008 financial crisis.²⁵, ²⁶

Key Takeaways

• Redeemable preferred stock allows the issuing company to repurchase its shares at a predefined price and date.²⁴
• This feature offers flexibility for the issuer to manage its capital costs, especially in a declining interest rate environment.²³
• Investors typically receive a call premium if their shares are redeemed, compensating them for potential reinvestment risk.
• Redeemable preferred stock is considered a hybrid security, blending characteristics of both debt and equity.²¹, ²²
• The terms of redemption, including the call price and call date, are stipulated in the stock's prospectus.²⁰

Formula and Calculation

While there isn't a single universal formula to calculate the value of redeemable preferred stock that applies to all scenarios, its valuation often considers the present value of future dividend payments and the call price if the stock is redeemed.

The present value of a preferred stock with a call feature can be conceptualized as:

$PV = \sum_{t=1}^{N} \frac{D}{(1+r)^t} + \frac{Call Price}{(1+r)^N}$

Where:

• ( PV ) = Present Value of the redeemable preferred stock
• ( D ) = Annual dividend payment
• ( r ) = Investor's required rate of return (discount rate)
• ( N ) = Number of periods until the call date or redemption

This formula assumes the stock will be called at the earliest possible call date, which is a common scenario when market interest rates fall below the preferred stock's dividend rate.

Interpreting the Redeemable Preferred Stock

Interpreting redeemable preferred stock involves understanding the balance of benefits and risks for both the issuer and the investor. For the issuing company, the redeemable feature provides a strategic tool for financial management. If prevailing market interest rates decline, the company can call back its higher-cost preferred shares and issue new ones at a lower dividend rate, effectively reducing its overall cost of capital.¹⁸, ¹⁹ This flexibility can be a significant advantage in optimizing the company's financial health.

From an investor's perspective, redeemable preferred stock offers a predictable stream of income through fixed dividends, often higher than those of common stock. However, the "callable" nature introduces call risk. If the stock is called, investors receive the call price, which may include a premium, but they then face the challenge of reinvesting their capital, potentially at a lower rate of return in the current market environment. Therefore, investors evaluate redeemable preferred stock by weighing the stable income against the possibility of early redemption and the associated reinvestment risk.

Hypothetical Example

Consider "Horizon Corp." that issues 100,000 shares of redeemable preferred stock with a par value of $100 per share and an annual dividend rate of 6%. The prospectus states that the company has the option to call these shares after five years at a call price of $105 per share.

Five years later, market interest rates have significantly declined, and Horizon Corp. can now issue new preferred stock at a 3% dividend rate. To reduce its financing costs, Horizon Corp. decides to exercise its call option.

Horizon Corp. sends a notice to all holders of its redeemable preferred stock, informing them that the shares will be redeemed on a specific date. On the redemption date, each shareholder receives $105 per share (the call price), along with any accrued and unpaid dividends up to that date. For an investor holding 100 shares, they would receive 100 \times $105 = $10,500 in capital, plus any final dividend payment. This allows Horizon Corp. to replace the 6% preferred stock with new 3% preferred stock, saving substantially on future dividend payments.

Practical Applications

Redeemable preferred stock is frequently used by corporations, particularly financial institutions, as a financing tool.¹⁵, ¹⁶, ¹⁷ Companies often issue these securities to raise capital without diluting the ownership stake of common shareholders. When market conditions, such as declining interest rates, make it financially advantageous, issuers can redeem these shares to reduce their cost of capital. This has been observed with major financial institutions. For example, Bank of America has announced the redemption of various series of its preferred stock on multiple occasions to manage its capital structure.¹¹, ¹², ¹³, ¹⁴

Beyond capital raising and cost management, redeemable preferred stock can also be utilized to optimize a company's balance sheet and debt-to-equity ratios. From a regulatory perspective, such as for banks, preferred stock can help meet capital requirements without incurring additional debt.¹⁰ The ability to call these shares provides a mechanism for companies to adapt to evolving financial landscapes and maintain a flexible capital structure.

Limitations and Criticisms

While redeemable preferred stock offers flexibility for issuers, it presents certain limitations and criticisms for investors. The primary concern for investors is call risk. If interest rates decline significantly, the issuer is likely to call the preferred stock, forcing investors to reinvest their capital in a lower interest rate environment. This can lead to a reduction in future income, especially for income-focused investors.

Another limitation is the potential for limited capital appreciation. Because redeemable preferred stock often has a defined call price, its market price may not rise significantly above that price, as investors anticipate the possibility of redemption. This contrasts with common stock, which can offer unlimited upside potential.⁹ Furthermore, despite their "preferred" status, preferred stocks are subordinate to corporate bonds in the event of bankruptcy, meaning bondholders are paid before preferred shareholders.⁸ Financial Industry Regulatory Authority (FINRA) rules require firms to have procedures for allocating partially redeemed callable securities to ensure fair treatment among customer accounts.⁶, ⁷

Redeemable Preferred Stock vs. Convertible Preferred Stock

Redeemable preferred stock and convertible preferred stock are distinct types of preferred shares, each with unique features primarily benefiting either the issuer or the investor.

The key difference lies in who holds the option. With redeemable preferred stock, the company holds the right to "call" or buy back the shares, typically when interest rates fall, allowing them to refinance at a lower cost. In contrast, convertible preferred stock gives the investor the right to convert their preferred shares into a predetermined number of common shares, often appealing when the common stock's price rises significantly.

FAQs

What does it mean if preferred stock is redeemable?

If preferred stock is redeemable, it means the company that issued the stock has the option to buy it back from shareholders at a specified price and date. This is also known as "callable" preferred stock.⁵

Why do companies issue redeemable preferred stock?

Companies issue redeemable preferred stock to raise capital while maintaining flexibility. If market interest rates decrease, they can call back the existing, higher-dividend shares and issue new ones at a lower dividend rate, thereby reducing their financing costs.³, ⁴

What happens to investors when redeemable preferred stock is called?

When redeemable preferred stock is called, investors receive the predetermined call price for each share, plus any accrued but unpaid dividends. They then have their capital returned and must find new investment opportunities.²

Is redeemable preferred stock good for investors?

Redeemable preferred stock offers investors predictable fixed dividend income, which can be attractive. However, the risk is that the stock may be called when interest rates are low, forcing investors to reinvest their money at a potentially lower rate of return.

How does the call price work for redeemable preferred stock?

The call price is the specific price at which the issuing company can repurchase the redeemable preferred stock. This price is typically set at or slightly above the stock's par value and is outlined in the stock's original prospectus.¹