Preferred Stocks & Convertibles
Topic 8
I. Preferred Stocks
1
A. Characteristics
• 1. Hybrid Securities
– a.
– b.
– c.
– d.
Pay Dividends
CS
Equity Ownership
CS
Prior Claim
Bond
Fixed Dividends Bond
2
A. Characteristics (continued)
• 2. Advantages / Disadvantages
– a.
– b.
– c.
– d.
– e.
High Current Income
Safety
Low Unit Cost ($10-$25/Share)
Inflation -- not a good hedge
Lacks capital gain potential
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A. Characteristics (continued)
• 3. Sources of Value
– a. Dividend Yield
P=D/K
D = Dividend
K = Required Return
4
B. Usual Features of
Preferred Stock
• 1. Voting
– Usually nonvoting but does have contingent voting
rights. This is the right to elect some of the directors.
– Usually have the right to vote for approval on the
issuance of additional Preferred Stock.
• 2. Maturity and Call
– Typically Preferred Stock has no maturity date (like
C/S).
– The typical Preferred is callable.
5
B. Usual Features of
Preferred Stock (continued)
• 3. Sinking Fund
– 40% of Preferred issues have this agreement,
usually found in public utility Preferred
• 4. Dividends
– Cumulative VS Noncumulative
• 5. Convertibility
– Preferred is typically nonconvertible
– 1/3 of Preferred are convertible
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C. Yields
• 1. Compared with Bonds, Preferred are
typically higher. Why?
• 2. Pattern
– Similar to Bonds
• 3. Yields have tended to be relatively
unstable. This suggests a higher degree of
risk.
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D. Analysis of Preferred Stock
• 1. Assets/Share
– Example:
• Assume: TA = $110 TD = $50
• 1 million Preferred Shares
• with $10 par
– The “Net Asset/Share” would be
$60 million
= $60/Share
1 million shares
– This would cover Par 6 x
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D. Analysis of Preferred Stock
(continued)
• 2. Preferred Stock Ratings
– S&P Rating : AAA to C
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E. Preferred Stock as an Investment
• 1. Better suited for the Institution
• 2. Does not share in earnings
• 3. Does not have the security of Bonds,
more volatile
• 4. Only becomes attractive when the
yield is greater than Bonds
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Preferred Stocks & Convertibles
Topic 8
II. Convertible Securities
11
A. Characteristics
• 1. Hybrid possessing the features and
performance qualities of both fixed income
and equity securities
• 2. Should be viewed primarily as a form of
equity
• 3. Provide the “Equity Kicker”
• 4. A “Deferred Equity”
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B. Convertible Bonds
• 1. Issued as Debentures
• 2. Over time, may be converted into a certain
number of shares
• 3. Normally “Freely Callable” which may lead
to “Forced Conversion”
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B. Convertible Bonds (continued)
• 4. Options at forced conversion
– Convert to shares
– Redeem the Bond for cash at the stipulated call price
• 5. Conversion Privilege
– Stipulates the conditions and nature of the conversion
– Initial waiting period of 6 months to 2 years
– Conversion period may have a limited life
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B. Convertible Bonds (continued)
• 6. Conversion Ratio
– Number of common shares which the Bond may
be converted into
– Example: A Ratio of 20 states that a $1000 Bond
may be converted into 20 shares of the Common
• Implied conversion price is $50/Share
• Ratios are normally fixed but can be variable
• Ratios are adjusted for stock splits
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C. Sources of Value of Convertibles
• 1. Convertible Securities trade like a
Common Stock. They derive value from the
Common Stock.
– Example: Assume a Convertible has a ratio of 20 and
the Stock sells for $45. If the conversion price is $50
($1000/20), then for every point the stock goes up or
down the Convertible Security will move by 20x.
– Hence, Price of Convertible Security in example is:
$45 * 20 = $900
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D. Risk
• 1. Risk is a function of the issue’s fixed
income and equity characteristics.
• 2. Fixed income nature defines its floor
price.
• 3. Equity nature defines its ceiling price.
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