- There are many types of preferred stock; the most common are cumulative and non-cumulative. Cumulative stock provides that if any dividend is not paid, it is added to the amount of the next dividend and must be paid before maturity of the preferred issue. In addition, no common stock dividend may be paid until all cumulative dividends are paid. Cumulative stock is priced by the current market price plus any dividends due.
Non-cumulative dividends do not accrue to the next payment date, and the company has no requirement to make such payments. - Convertible preferred stock is preferred stock that can be converted into common shares of the issuing company. Convertible preferred shares are issued with a specific formula for their conversion at the option of the issuer, not the buyer, and the issuer pays a lower interest rate.
If the stock rises, the shares can be converted and the capital will be treated as equity. Because the conversion feature is based on a premium to the current price of the stock, the investor usually must hold the preferred for a period of time until the conversion price is reached. - Participating preferred stock is usually used in private placements, which are deals between two companies that are not intended to be offered to the general public. They are very illiquid and have no secondary market for trading. Thus, private placements are usually priced at a discount to publicly traded market prices.
Participating preferred also is used as a financing tool for start-up companies and projects that need to be built over a period of time. The participating dividend is a percentage of cash flow from the project. Redemption values are computed by the redemption of the principal and a value for the future cash flow. - Credit ratings are the single most important determinant of a preferred stock's value. The lower the credit rating, the greater the cost of the financing. Ratings are provided by the three major credit-rating agencies: Moody's; Standard and Poor; and Fitch Rating Service. Because preferred stock has credit preference to the common stock of the company, the ratings are higher than those of the common stock and near those of any bond issuance.
- Preferred stocks, exclusive of participating preferred and convertible preferred, tend to trade at a rate, or "spread," off a bond. If a bond is yielding 5 percent, the preferred might trade at "50 off," or a 5.50 percent rate. When interest rates rise, bond and preferred yields rise as well, thus lowering the value of the preferred. Because preferred does not usually carry a maturity but rather a mandatory redemption, or call, by the issuer, preferred yields tend to trade with less volatility than bonds.
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