A preferred stock is a hybrid security issued by a company that shares characteristics with both bonds and stocks. Like bonds, a preferred stock is primarily an income security, paying investors a specified rate which is typically much higher than common stock dividends. Like common stock, preferred stock is listed as an equity security on a company's balance sheet, as opposed to a debt security, like a bond. Preferred stock typically trades on an exchange and pays investors dividends, rather than interest. Adjustable-rate preferred stock pays a fluctuating dividend, unlike the fixed dividend of regular preferred stock.
Corporate Capital Structure
In the event of a corporate default or other financial difficulty, bondholders have a priority claim on company assets, ahead of all shareholders. However, preferred shareholders have a senior claim to assets over common stockholders, which own junior securities. A company is required to pay preferred dividends ahead of all common dividends, hence the name "preferred" stock. This applies to all preferred stock issued by a company, including adjustable-rate preferred.
Adjustable Rate
An adjustable-rate preferred pays a dividend that fluctuates in rate. The rate on an ARP is usually tied to the rate on another security such as Treasury bills. As bond and preferred stock values decline as interest rates go higher, the adjustable-rate feature helps reduce the interest-rate risk of ARPs. As the interest rate adjusts higher, the new rate compensates investors for the decline in share price and simultaneously makes the securities more valuable to other investors.
Dividend Floor
Most ARPs have a pre-determined dividend rate floor, beneath which the dividend rate cannot fall. In periods of low or falling interest rates, this helps make ARPs much more valuable, as the preferreds will pay above-market rates with a guarantee that the dividend cannot decrease.
Call Provisions
Most preferred stocks, including ARPs, have a call feature that allows a corporate issuer to redeem the preferreds at a specified date and price. Generally, a company will call an ARP away from investors when it most benefits the company, rather than the investor. For example, if interest rates fall to two percent and an ARP has a floor of four percent, a company might choose to call in the ARP and issue a new ARP at a rate of two percent.
Perpetual Issuance
Unlike bonds, which have a stated maturity date at which investors can expect to receive their principal back, ARPs are often issued on a perpetual basis, meaning they have no maturity date. The longer a preferred stock has until maturity, the more its shares fluctuate in response to moves in interest rates. Thus, an ARP with no maturity date can trade down substantially in value in a period of rapidly rising interest rates. Investors are never entitled to the return of their invested capital in a perpetual preferred, and they may be forced to sell the shares in the open market at a loss if they need the capital.
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