C HAPTER 18, Lecture

1. CHAPTER18, Lecture Preferred Stocks and Convertible Securities Chapter Sections: Bond Indentures (pages 589 to 592) Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond Prices Preferred Stock (page 598) Lecture Notes

2. What are Preferred Stocks? • Stocks that have a prior claim (ahead of common stocks) on the income and assets of the issuing firm • a.k.a. Hybrid Securities, Fixed-income Stocks • Preferred Stocks pay a fixed dividend • Percentage of “par value” • In much the same way as a bond pays a fixed interest amount • Preferred Stocks represent equity • Therefore, doesn’t count as debt on the corporate balance sheet In case of corporate default, preferred stocks have priority over common stockholders but are subordinate to bonds.

3. Preferred Stock • Advantages • Highly predictable income stream (typically) • Excellent record of meeting dividend payments • Tax benefits if owned by another corporation • Disadvantages • Susceptibility to inflation • Much like bonds • Dividends can be suspended or postponed • Unlike bonds, which must pay interest or risk default • Lack potential of substantial capital gains • Unlike common stock • Normally, do not pay as well as bonds

4. Preferred Stock versus Bonds

5. Yield of Preferred Stocks • The dividend yield of preferred stock is annual dividend income divided by the stock price • Much the same as the current yield of a bond Annual dividend income Dividend Yield = ────────────────── Current market price Example: Annual dividend income = $2 Current market price = $27.50 Dividend Yield = $2 / $27.50 = 7.27%

6. Pricing of Preferred Stocks • As with bonds, the prices fluctuate mostly inversely to interest rates • Although there is a greater risk of non-payment of dividends (Recall: The dividends are not mandatory) • Unlike bonds, where the bond issuer is in default if the interest is not paid Dividend income Price = ────────────────── Prevailing interest rates Example: Dividend income = $2.50 Prevailing interest rates = 12% Price = $2.50 / 12% = $20.83

7. Characteristics of Preferred Stock • Conversion Feature of Preferred Stocks • a.k.a. “Convertible Preferred,” “Convertibles” • Many preferred stocks are “convertible” • Allows the holder of a preferred stock to convert to a specified number of shares of the issuing company’s common stock • The investor can then share in the growth of the common stock (more about convertibles later) • Adjustable-rate Preferred Stocks • a.k.a. “Floating-rate Preferred,” “Floaters” • Dividends are adjusted periodically in line with prevailing interest rates • Often tied to Treasury rates or other index

8. Characteristics of Preferred Stock (continued) • Senior Preferred Stocks • a.k.a. “Preference Stock,” “Prior Preferred” • Some companies issue different classes of preferred • The most senior are guaranteed to be paid before the less senior (a.k.a. junior preferred), etc. • Cumulative versus Non-cumulative Preferred • Preferred dividends (just like common dividends) are not mandatory and can be skipped • If the preferred stock is cumulative, then the foregone dividends are said to be “in arrears” • The “in arrears” dividends must be paid before any other dividends can be paid (preferred or common)

9. Characteristics of Preferred Stock (continued) • Callable versus Non-Callable Preferred • As with bonds, some preferred stocks can be “called” • If interest rates fall, the issuer wants to “refinance” the preferred stock at a lower dividend rate • Participating Preferred • Rare form of preferred that allows investors to “participate” in earnings beyond the stated dividend rate What is the bottom line on preferred stock? Preferred stock is normally owned by corporations. Some individual investors may acquire a taste for them but it is my opinion you are better off with common stock for growth and income and bonds for income.

10. Convertible Securities • Fixed-income obligations that can be converted into a specified number of shares of the issuing company’s common stock • Convertible bonds and convertible preferred stock • a.k.a. Deferred Equity • “Equity kicker” – ability to share in the possible appreciation of common stock • Example: • $1,000 bond, convertible to 20 shares of common stock 20 shares of stock $1,000 bond

11. Convertible Securities (continued) • Conditions of the conversion feature of convertible securities • Conversion period • Time period during which a convertible issue can be converted • Normally deferred for a period of years • Conversion ratio • Number of shares of common stock into which a convertible security can be converted • Example: 20 shares for one $1,000 bond • Conversion price • Price per share at which common stock will be delivered to the investor (par value/conversion ratio) • Example: $1,000 / 20 = $50 conversion price

12. Convertible Securities (continued) • Conversion value • Indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value • Conversion value = Conversion ratio * Market price • Example: • Conversion ratio 20 for 1, stock price $60 • 20 * $60 = $1,200 • However, the convertible bond would probably sell for more than $1,200 because of the ability to convert to the stock plus the interest the bond is generating (conversion premium next slide)

13. Convertible Securities (continued) • Conversion premium • The amount by which the market price of a convertible security exceeds its conversion value • Conversion premium = Market Price – Conversion Value • Example: • 8%, $1,000 bond with conversion ratio of 20 • Stock trading at $60.00 • Conversion value = 20 * $60 = $1,200 • But the bond is selling for $1,400 • Conversion premium = $1,400 – $1,200 = $200

14. Convertible Securities (continued) • Conversion equivalent • The price at which the common stock would have to sell in order to make the convertible security worth its present price • a.k.a. Conversion parity • Market price of convertible / Conversion rate • Example: • Convertible bond selling at $1,400, 20 to 1 ratio • $1,400 / 20 = $70 per share • Market price of common stock should be close to $70 • But would most probably be less than $70 because of the convertible security’s conversion premium

15. Convertible Price Behavior

16. Convertible Securities • Bottom Line on Convertibles? • Convertible securities allow you to partake in the potential capital appreciation of the common stock • With less risk because of the income from the convertible bond or convertible preferred stock • If the stock price is below the conversion price, then the convertible security’s price will be kept up because of its value from producing income (bond or preferred stock) • But you pay for the reduced risk via the conversion premium Again, my personal opinion is that I believe individual retail investors are best served by focusing their attention on common stocks for growth and income and bonds for income but there are always exceptions.

17. CHAPTER18 – REVIEW Preferred Stocks and Convertible Securities Chapter Sections: Bond Indentures (pages 589 to 592) Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond Prices Preferred Stock (page 598) Lecture Notes Next: Chapter 11, Diversification and Risky Asset Allocation