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Preferred Stocks: Frequently Asked Questions
You’d think that preferred shares would be an arcane topic of little
interest. But, in fact, my recent columns on preferreds generated
unusually heavy volumes of mail.
If you missed those columns, investors buy preferred shares for the steady
dividends; they usually have little or no appreciation potential. However,
due to current market conditions, preferreds are paying unusually high
dividend yields and many have serious price appreciation potential. Here
are the most frequently asked questions.
Q) What’s to keep a company from
cancelling its preferred dividend payments if it runs short of cash?
A) Similar to bonds, companies
sell preferred shares to raise cash. Nobody would buy a firm’s preferreds
if they thought that it wasn’t going to pay the dividends as promised.
Thus cancelling or suspending preferred dividends would be a last resort
for most firms because doing so would prevent them from selling preferreds
in the future.
By the way, a company cannot suspend or cancel its preferred dividends
without first cancelling its common stock dividends.
Q) If a company were to suspend
its preferred dividends, would it be required to repay the dividends that
it withheld during the suspension period?
A) When initially sold, a firm
designates its preferred share dividends as “cumulative” or “non
cumulative.” For cumulative preferreds, the company is obligated to pay
the dividends. If it suspends the payouts, it still owes the money and
must catch up on any missed dividends by the preferred maturity date or
when it calls (redeems) the preferred shares. Also, it must catch up on
skipped preferred payouts before it pays any dividends on its common
stock.
In the case of “non-cumulative” shares, the issuing firm has no obligation
to make up skipped payouts.
Q) I’ve heard politicians say
that the dividends should be suspended on the preferred shares of banks
and other firms that receive bailout money from the government. Is that
likely?
A) More than 20 banks have
signed up to receive cash from the Treasury Department via the Troubled
Assets Relief Program (TARP). The amounts range from $20 million or so for
the smallest banks up to $25 billion for the largest banks.
But the government isn’t giving the money away. It’s buying specially
issued preferred shares from the banks. The banks must pay
5% annual dividends on the preferreds for the
first three years and 9% thereafter (Most banks
will probably buy back the shares before the 9%
rate kicks in). But there’s more. The banks must also give the Treasury
warrants (options) to purchase each bank's common stock at the prevailing
price before it bought the preferreds. Since bank share prices are
currently in the dumpster, the Treasury stands to make money on those
shares if they return to their normal trading range. The value of the
common stock covered by the warrants amounts to 15%
of the Treasury’s preferred investment.
The banks must pay the dividends on the TARP preferreds before paying
dividends on other preferreds. Otherwise, there is nothing in the TARP
agreement that precludes banks from paying preferred dividends. So, baring
an unexpected balance sheet meltdown, the TARP agreement won’t stop banks
from paying preferred dividends.
Q) The ticker symbols for the
preferreds that your mentioned in your column don’t work on my broker’s
site. How do I know whether I am buying the right security?
A) Unlike regular stocks, there
is no standardized ticker symbol format for preferreds. In fact, it seems
that every broker and many websites use different symbols for the same
stock. For instance, the Bank of America Series D shares that I mentioned
in the column can be found using ticker BAC-D on MSN Money (moneycentral.msn.com)
and on TD Ameritrade. But Yahoo (finance.yahoo.com)
uses BAC-PD, Fidelity Investments uses BAC/PI and E*Trade uses BAC.PR.D.
I’ve found that the easiest solution is to use your broker’s symbol lookup
function. Usually, entering “Bank of America” will bring up a list of all
BofA preferreds.
Q) Do the value of preferreds
vary with prevailing interest rates?
A) Yes, like bonds, the value of
preferred shares depends on current interest rates. For instance, say
6% is considered an attractive yield and you buy
a preferred paying that rate for $100 per share. Thus, your preferred
shares are each paying dividends totaling $6 per year. Now, assume that
prevailing rates move up and otherwise similar new preferreds are paying
7%
Nobody is going to pay you $100 for your shares paying $6 per year when
they can buy new preferreds for the same price that are paying $7.
Thus, to sell your shares, you would have to reduce the price to the point
where its $6 annual dividend equates to 7%
interest. That works out to $85.72 per share. The same thing works in
reverse. Should prevailing rates drop to 5%,
your preferred shares would be worth $120 each.
In recent years, inflation has been held in check and prevailing interest
rates haven’t moved much. However, some fear that all of the cash the
government is pouring into the economy will stoke inflation. If that
happens, interest rates would rise.
Q) You said in your article that
Fannie Mae and Freddie Mac had stopped paying dividends on their preferred
shares. But I just received dividends on my Fannie Mae preferreds. What
gives?
A) Fannie Mae had declared
dividends on its preferreds before the government takeover. The government
allowed Fannie to pay those dividends as promised. But that’s the end of
it, at least for now. Fannie and Freddie’s preferred dividends will be
suspended until the Treasury Department gives the okay to resume paying
them. There has been no indication that that will happen anytime soon.
Thanks for sending me your questions, and please keep them coming.
published
11/10/08 |
