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CHAPTER 18, Lecture

Preferred Stocks and Convertible Securities

Chapter Sections:Bond Indentures (pages 589 to 592) Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond PricesPreferred Stock (page 598)Lecture Notes

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What are Preferred Stocks? Stocks that have a prior claim (ahead of

common stocks) on the income and assets of the issuing firm a.k.a. Hybrid Securities, Fixed-income Stocks Preferred Stocks pay a fixed dividend

Percentage of “par value” In much the same way as a bond pays a fixed

interest amount Preferred Stocks represent equity

Therefore, doesn’t count as debt on the corporate balance sheet

In case of corporate default, preferred stocks have priority over common stockholders but are subordinate to bonds.

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Preferred Stock Advantages

Highly predictable income stream (typically) Excellent record of meeting dividend payments Tax benefits if owned by another corporation

Disadvantages Susceptibility to inflation

Much like bonds Dividends can be suspended or postponed

Unlike bonds, which must pay interest or risk default Lack potential of substantial capital gains

Unlike common stock Normally, do not pay as well as bonds

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Preferred Stock versus Bonds

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Yield of Preferred Stocks The dividend yield of preferred stock is annual

dividend income divided by the stock price Much the same as the current yield of a bond

Annual dividend incomeDividend Yield = ──────────────────

Current market price

Example: Annual dividend income = $2Current market price = $27.50Dividend Yield = $2 / $27.50 = 7.27%

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Pricing of Preferred Stocks As with bonds, the prices fluctuate mostly

inversely to interest rates Although there is a greater risk of non-payment of

dividends (Recall: The dividends are not mandatory) Unlike bonds, where the bond issuer is in default if

the interest is not paid

Dividend incomePrice = ──────────────────

Prevailing interest ratesExample:

Dividend income = $2.50Prevailing interest rates = 12%Price = $2.50 / 12% = $20.83

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Conversion Feature of Preferred Stocks a.k.a. “Convertible Preferred,” “Convertibles”

Many preferred stocks are “convertible” Allows the holder of a preferred stock to convert

to a specified number of shares of the issuing company’s common stock The investor can then share in the growth of the

common stock (more about convertibles later) Adjustable-rate Preferred Stocks

a.k.a. “Floating-rate Preferred,” “Floaters” Dividends are adjusted periodically in line with

prevailing interest rates Often tied to Treasury rates or other index

Characteristics of Preferred Stock

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Senior Preferred Stocks a.k.a. “Preference Stock,” “Prior Preferred” Some companies issue different classes of

preferred The most senior are guaranteed to be paid before

the less senior (a.k.a. junior preferred), etc. Cumulative versus Non-cumulative Preferred

Preferred dividends (just like common dividends) are not mandatory and can be skipped

If the preferred stock is cumulative, then the foregone dividends are said to be “in arrears” The “in arrears” dividends must be paid before any

other dividends can be paid (preferred or common)

Characteristics of Preferred Stock(continued)

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Callable versus Non-Callable Preferred As with bonds, some preferred stocks can be

“called” If interest rates fall, the issuer wants to “refinance”

the preferred stock at a lower dividend rate Participating Preferred

Rare form of preferred that allows investors to “participate” in earnings beyond the stated dividend rate

Characteristics of Preferred Stock(continued)

What is the bottom line on preferred stock? Preferred stock is normally owned by corporations. Some individual investors may

acquire a taste for them but it is my opinion you are better off with common stock for growth and income and bonds for income.

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Fixed-income obligations that can be converted into a specified number of shares of the issuing company’s common stock Convertible bonds and convertible preferred stock a.k.a. Deferred Equity “Equity kicker” – ability to share in the possible

appreciation of common stock Example:

$1,000 bond, convertible to 20 shares of common stock

$1,000 bond 20 shares of stock

Convertible Securities

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Conditions of the conversion feature of convertible securities Conversion period

Time period during which a convertible issue can be converted

Normally deferred for a period of years Conversion ratio

Number of shares of common stock into which a convertible security can be converted

Example: 20 shares for one $1,000 bond Conversion price

Price per share at which common stock will be delivered to the investor (par value/conversion ratio)

Example: $1,000 / 20 = $50 conversion price

Convertible Securities(continued)

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Convertible Securities Conversion value

Indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value Conversion value = Conversion ratio * Market price Example:

Conversion ratio 20 for 1, stock price $60 20 * $60 = $1,200 However, the convertible bond would probably sell for

more than $1,200 because of the ability to convert to the stock plus the interest the bond is generating (conversion premium next slide)

(continued)

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Convertible Securities Conversion premium

The amount by which the market price of a convertible security exceeds its conversion value Conversion premium = Market Price – Conversion Value

Example: 8%, $1,000 bond with conversion ratio of 20 Stock trading at $60.00 Conversion value = 20 * $60 = $1,200

But the bond is selling for $1,400

Conversion premium = $1,400 – $1,200 = $200

(continued)

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Convertible Securities Conversion equivalent

The price at which the common stock would have to sell in order to make the convertible security worth its present price

a.k.a. Conversion parity Market price of convertible / Conversion rate Example:

Convertible bond selling at $1,400, 20 to 1 ratio $1,400 / 20 = $70 per share Market price of common stock should be close to $70

But would most probably be less than $70 because of the convertible security’s conversion premium

(continued)

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Convertible Price Behavior

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Bottom Line on Convertibles? Convertible securities allow you to partake in the

potential capital appreciation of the common stock With less risk because of the income from the

convertible bond or convertible preferred stock If the stock price is below the conversion price, then

the convertible security’s price will be kept up because of its value from producing income (bond or preferred stock)

But you pay for the reduced risk via the conversion premium

Convertible Securities

Again, my personal opinion is that I believe individual retail investors are best served by focusing their attention on common stocks for growth

and income and bonds for income but there are always exceptions.

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CHAPTER 18 – REVIEW

Preferred Stocks and Convertible Securities

Next: Chapter 11, Diversification and Risky Asset Allocation

Chapter Sections:Bond Indentures (pages 589 to 592) Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond PricesPreferred Stock (page 598)Lecture Notes