HYBRID SECURITIES
Preferred Stock
Preferred stock is a hybrid instrument; it is like debt but it is also like equity. The
dividends on preferred stock are generally set at a specific dollar amount per share, often
expressed as a percentage of par value. There is also dividend preference – the company
cannot pay any common stock dividends until the preferred stock dividends have been paid.
Typically, preferred stock dividends are cumulative so that all dividends in arrears on preferred
stock must be paid before common stockholders can be paid anything. It is not uncommon that
dividends in arrears also carry an interest rate that accumulates.
In the event of liquidation, preferred shareholders will be repaid the par value of the
preferred stock.
While the standard type of preferred stock pays a constant dividend and never matures,
there is a wide variety of provisions that may be included in a preferred stock issue:
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Sometimes the preferred stockholder get to vote.
There may be a maturity date and sinking fund provision.
Sometimes there is a call provision.
On rare occasion, there is what is known as participating preferred stock that
participates in the profits up to a limit during unusually good years.
Very often the preferred stock is convertible into common shares. Many times the
ability to vote is linked to the conversion feature and the preferred stockholders can
vote “as if” they had converted into common stock.
You will often see preferred stock used in small companies that need to raise additional
capital. The investors, typically venture capitalists, will invest money in the form of convertible
preferred stock. Thus, if the company prospers and the common stock becomes worth a
significant amount, the investor can convert to common stock and cash in on the company’s
good fortunes. On the other hand, if the company ultimately founders or fails, the investor is
first in line to get paid dividends or to be repaid from any proceeds that remain after liquidation.
Advantages of Preferred Stock to the Investor
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Relatively steady income (relative to common stock).
Preference over common stock in liquidation.
Dividends paid to corporations owning the preferred stock are excluded from income to as
much as a 70% extent.
Disadvantages of Preferred Stock to the Investor
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Returns are limited.
There is no enforceable right to dividends (unlike interest payments that must be paid
annually).
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There is high risk due to price fluctuations. Recall from our discussion of valuation of
securities that preferred stock is a perpetuity and perpetuities are the most sensitive to
changes in interest rates.
Advantages of Preferred Stock to the Company
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There is no fixed charge that must be paid each year.
There is no maturity.
No dilution of control (unless convertible).
The cost is less than the cost of common equity. While the first two advantages are the
same as the advantage of using common stock, the cost is less. Why? Because the risk to
the investor is less than that of common stockholders.
Disadvantages of Preferred Stock to the Company
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Cost is higher than debt.
Dividends are not tax-deductible.
From the perspective of a bondholder, preferred stock is like common equity. It provides
for more assets that generate income that is used to pay lenders their interest first and provides
more asset that can be liquidated to pay lenders their principal first if the firm goes bankrupt.
From the perspective of a common stockholder, on the other hand, preferred stock is like
debt. The preferred stock dividends must be paid first (and also act as leverage in terms of
magnifying the variability of income) and the preferred stockholders are ahead of the common
shareholders in the event of liquidation (just like lenders).
Preferred Stock Valuation
The classic version of preferred stock is a share that pays a fixed dollar amount of
dividend and never matures. It is, therefore, a perpetuity. The formula for the value of a share
of preferred stock is
Value of Preferred Stock 
Dividend
rp
Since the “plain vanilla” type of preferred stock is a perpetuity, its value is very sensitive
to changes in interest rates.
Options
Typically, when people talk about options on stocks, they are referring to the
standardized options that are traded on exchanges. These standardized options are for 100
shares of stock and have maturity dates that go up to nine months in three-month intervals.
Also, the exercise price (or strike price) is always in specified intervals of two and one-half or
five dollar increments. A call option gives the holder of the option the right to buy 100 shares of
stock at a set price (strike price, or exercise price) during a set period of time (until expiration).
A put option gives the holder (owner) of the option the right to sell 100 shares of stock at a set
price during a set period of time. Options are part of a set of securities referred to as derivatives
due to the fact that their value is derived from some underlying asset.
An option’s value is a function of five factors:
1.
2.
3.
4.
5.
Market price of the stock
Strike price of the option
Time to maturity of the option
Volatility of the underlying stock
Risk-free rate of interest
The following graph illustrates the value of a call option at different market prices of the
underlying stock given a set strike price, maturity date, etc.
Value of
Option
Intrinsic
Value
Market Value
0
Stock Price
The “intrinsic value” (blue line) is the value of the option if it were to be exercised at that point in
time.
Intrinsic Value = Max(M-S,0)
Note, however, that the market value is always higher than the intrinsic value due to the
speculative appeal of an option (except on expiration date when the two should converge). For
example, if the exercise price is higher than the market price, the intrinsic value is zero since it
is irrational that one would pay a higher price to buy the stock through an option exercise than
what it would cost to purchase on the open market. As long as there is some time before the
expiration of the option, there is a chance that the market price will move above the strike price,
thereby making the option “in the money” and worth exercising.
Warrants and Convertibles
A firm must often add features to make its debt more attractive. In times of high interest
rates, it is undesirable to raise money in general because the rate of interest paid on debt will be
high and stock prices will be low. In order to help offset the high interest rates that prevail, a
firm may add a sweetener to its debt in order to make it more attractive to investors.
Warrants
A warrant is an option to buy stock at a set price. In this sense, it is an option. The
difference is that a warrant typically does not expire for many years. A warrant will often be
issued in conjunction with a bond issue. If you buy a bond, you receive a warrant that entitles
you to purchase a fixed number of shares at a fixed price during a fixed period of time.
Sometimes, the exercise price will increase over time in order to encourage the warrant holders
to exercise the option sooner. The intrinsic value of the warrant is
W = Max{0,N*(M-S)}
Where
N = the number of shares the warrant entitles you to buy
M = the market price of the stock
S = the subscription price of the warrant to buy the stock
A warrant is generally issued at the same time as a fixed income security (bond or preferred
stock) in order to make the security more attractive to investors.
At the time of the issue, the subscription price is generally set anywhere from 15%-20%
above the market price. Consequently, it does not make sense to exercise the warrant at the
time of issuance. However, the warrant’s speculative appeal lies in the fact that the stock price
may increase substantially in the future, making the warrant valuable.
If an investor had to choose between two identical bonds with identical maturities and
paying and identical rate of interest, but with one bond offering a warrant that, although not
worth exercising at the time of issuance, the bond with the warrant would be perceived as more
valuable since the stock may appreciate substantially. Since investors would prefer the bond
with the warrant, what can we do to make investors indifferent between the two bonds? The
easiest way to make the bond with the warrant less attractive (i.e., equivalent to the straight
bond without a warrant) is to lower the coupon rate of interest that it pays.
A warrant is detachable from the bond. That is, a separate market exists for the warrant.
If you buy a bond with a warrant attached, you can keep the bond and sell the warrant or keep
the warrant and sell the bond. Also, just like an option, a warrant will sell for more than its
intrinsic value (as in the above equation) since it has speculative appeal. Just as you can buy
the price movement of a share of stock using a call option, you can “buy” the right to N shares of
stock simply by purchasing the warrant.
The risk on the downside of purchasing a warrant is limited to the amount that is paid for
the warrant which is less than if you purchased the stock. On the other hand, the upside
potential is unlimited. The effect of purchasing a warrant is the leverage that is provided – both
gains and losses are magnified.
Convertible Bonds
Just as warrants make a bond more attractive to investors, adding a conversion feature
makes a bond more attractive. A convertible bond gives the bondholder the right to convert the
bond into a specified number of shares of common stock. The number of shares that a
convertible bond is convertible into is referred to as the conversion ratio. Typically, the
number of shares that a bond is convertible into is specified through what is known as the
conversion price. In this sense, a convertible bond is said to have an embedded option; i.e.,
the bond comes with a non-separable option to “purchase” stock at the strike price of
surrendering the bond.
Conversion Price
=
Par Value
Conversion Ratio
Thus, if a $1,000 par value bond is convertible into 20 shares of common stock, the conversion
price will be $50 per share. The reason for expressing the conversion ratio as a conversion
price arises from the fact that most convertible bonds are protected against dilution. If a firm
were to declare a two-for one stock split, for instance, the conversion price would be cut in half
(i.e., the number of shares that the bond is convertible into would be doubled).
As in the case of warrants, convertible bonds are generally issued when interest rates
are high (a bad time to sell debt) and stock prices are low (a bad time to sell equity). Also, the
conversion price is generally set at 15%-20% above the current market price of the stock at the
time of issuance, so the appeal is strictly speculative.
Consider the following graph:
$
Conversion Value
Call Price
Market
Price
Par Value
Bond Value
Time
There are two ways of looking at the convertible bond: first, it can always be held as a
straight bond. Since the conversion feature will allow the bond to pay a slightly lower rate of
interest than if it were non-convertible (a “straight” bond), its bond value is at a discount. This is
referred to as the “floor” of the convertible bond’s value since it can never be worth less than its
value as a straight bond. (See the red line.)
On the other hand, it can be viewed as if it were converted into common stock. Its
conversion value is equal to the number of shares that it is convertible into times the market
price per share of stock.
Conversion Value = Conversion Ratio * Market Price per Share
Since stock prices are generally expected to increase over time, the conversion value of the
convertible bond is portrayed as increasing over time as well.
A company typically includes a call provision on a convertible bond. If an investor had
total discretion as to when they wanted to convert, what would motivate the investor to convert
from a bond to stock? An investor would voluntarily convert (prior to maturity) only if there was
more income being paid to shareholders than to bondholders. In particular, assume that the
convertible bond pays an 8% coupon rate of interest. Since the typical stock today pays only
about a 2% dividend yield, then dividends would have to quadruple before an investor would
voluntarily convert the bond. The company, on the other hand can force conversion by
exercising the call provision. If, for example, the conversion value of the bond was $1,150 while
the call price was $1,050 what do you think an investor would do when the company sends a
letter saying “send us your bond within the next two months and we’ll send you $1,050”? The
investor would send the bond and say “here’s the bond, send me the stock (worth $1,150)”.
Why would a company want to force conversion? In order to stop paying interest at the high
rate. It will also make the debt/equity ratio look a lot better.
The advantage to the company of selling a convertible bond is that it can sell the bond at
a lower rate of interest than if it were a straight bond. In addition, it is contingently selling stock
at a higher price than the current market price of the stock.
Both warrants and convertibles act as sweeteners to make a bond issue more attractive.
The difference is that when warrants are issued, new money (the exercise price) comes into the
firm while the debt remains outstanding and must be retired. When a convertible bond is
exercised, on the other hand, the debt is converted into equity.