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Preferred Stocks & Convertibles. Topic 8 I. Preferred Stocks. A. Characteristics. 1. Hybrid Securities a. Pay Dividends CS b. Equity Ownership CS c. Prior Claim Bond d. Fixed Dividends Bond. A. Characteristics (continued). 2. Advantages / Disadvantages a. High Current Income
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Preferred Stocks & Convertibles Topic 8 I. Preferred Stocks
A. Characteristics • 1. Hybrid Securities • a. Pay Dividends CS • b. Equity Ownership CS • c. Prior Claim Bond • d. Fixed Dividends Bond
A. Characteristics (continued) • 2. Advantages / Disadvantages • a. High Current Income • b. Safety • c. Low Unit Cost ($10-$25/Share) • d. Inflation -- not a good hedge • e. Lacks capital gain potential
A. Characteristics (continued) • 3. Sources of Value • a. Dividend Yield P = D / K D = Dividend K = Required Return
B. Usual Features ofPreferred 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.
B. Usual Features ofPreferred 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
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.
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
D. Analysis of Preferred Stock (continued) • 2. Preferred Stock Ratings • S&P Rating : AAA to C
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
Preferred Stocks & Convertibles Topic 8 II. Convertible Securities
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”
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”
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
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
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
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.
