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After having written several articles recommending preferred stocks, some questions and comments from readers indicate that some folks don't understand the various provisions of preferred stocks and how they work. Some people thought they were like bonds and would be called at a certain date at the liquidation price. Some were confused about cumulative dividends while others did not recognize the relationship between the preferred and common stock if the preferred stock was convertible.

This article attempts to set out the differences between types of preferred stocks and explain what they mean for the investor. To help show these differences, this article will take various preferred issues as examples and attempt to explain what they mean.(Green and tan tables were taken from QuantumOnline.com)

Let's start with a traditional preferred stock of Zions Bancorporation (NASDAQ:ZION) : ZB-H.

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ZB-H offers 5.75% rate of return based upon the liquidation or call price ($25.00) of the stock. If the stock sells above or below the call price, the real rate of return changes according to the buy price of the issue. So if one buys it below $25.00 per share, the rate of return would be higher. On the other hand, if one buys it above $25.00 per share, the rate of return would be lower. The call date is 6/15/2019 which means that Zions Bancorporation cannot redeem or call the stock prior to that date. However the prospectus for this stock has a proviso that states that if the government does not allow the company to use the funds from this issue to be counted as Tier 1 capital, it could be called prior to that date. This is an unlikely event, but could occur if the government were to change the rules for the company. The only way to know this proviso is to read the prospectus for this issue.

ZB-H is non-cumulative, which means that if the directors of the company decide not to pay the dividend on any given quarter, one will not receive the dividend now or at a later time. The call date for this issue does not mean that the company must redeem or call the issue on 6/15/2019, but that it has the option to do so from that time forward. When and if the preferred is called, the owner of the issue will receive $25.00 for every share owned. Most preferred stocks unlike common stocks have a permanent call price. Therefore one cannot expect capital gains from a preferred issue unless one purchases it below the call price. Some preferred issues do not get the 15% ordinary dividend rate and others do. This particular issue gets the ordinary or 15% rate on dividends. A traditional preferred stock ranks below senior debt from banks and bonds but ranks senior to common shares of the company in the event of liquidation of the company.

RSO-B is somewhat different than ZB-H in that it is a cumulative preferred stock of Resource Capital Corp.(NYSE:RSO)

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It has many of the same characteristics as ZB-H except that it has an additional feature. Cumulative preferred issues must pay all the dividends to the owner. That is, if the directors defer the dividend for a period of time, all deferred dividends must be paid up to date prior to any dividends being declared on the common stock. Back dividends are paid to the holder at the time the directors declare the dividends. That means if one were an owner of the issue and the dividend was deferred and one sold it, the back dividends would be paid to the holder of record at the time it is declared.

From time to time, this makes it possible for an astute investor to purchase a cumulative preferred at the right time and get paid back dividends. One can sometimes purchase a stock like this at a distressed price and when the back dividends begin to be paid, the issue rises in price toward the call or liquidation price. There is also the danger that the company may be on the brink of disaster and for that reason is not paying the dividend. One must be careful to investigate the potential of the company reviving when investing in issues like this.

The other differences in this issue are:

  • Not eligible for the 15% tax rate
  • Issue cannot be called before 10/02/2017 for any reason
  • Owner of the issue may convert the issue for common stock if the following 2 conditions are met: Company is bought out and Company has not called the issue.

CHK-D is a cumulative convertible preferred stock of Chesapeake Energy Corp.(NYSE:CHK)

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It has many of the same characteristics of RSO-B with a kicker. This preferred offers one the opportunity to participate in the appreciation of the common stock. If the common stock price were to exceed $44.00, one can begin to participate in the appreciation of the common. One may convert the preferred for 2.2727 common stocks for each preferred stock one holds. Furthermore, the company can arbitrarily force conversion if the price of the common stock is 130% of the conversion price listed above for 20 of 30 consecutive days. Purchasing this preferred allows one to collect dividends until the company's stock gets to a certain point and then one can participate in the growth of the common stock.

AEB is a floating rate preferred stock of Aegon N.V.(NYSE:AEG)

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This preferred stock is very similar in characteristics to ZB-H listed first. The difference lies in the rate of return. The directors of the company reset the dividend paid each quarter. The payment is based upon the 3-month LIBOR + .875% or 4%, whichever is greater. This is a preferred stock that changes the rate of return based upon the London Interbank Offered Rate. LIBOR is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. This offers some protection when interest rates rise.

THGA is subordinated debenture of Hanover Insurance Group (NYSE:THG), but acts and trades like a preferred stock.

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THGA trades on the NYSE like a preferred issue, but in many respects it is like a bond. There are 2 significant differences from a bond; it trades in $25.00 denominations instead of $1000.00 and it trades flat. By trading flat, it means that buyer does not pay accrued interest at the time of purchase like one must pay on a bond. Unlike many preferred stocks, this issue must be redeemed by the company on 3/30/2053 at the liquidation or call price.

MTCN is a mandatory convertible subordinated note of ArcelorMittal (NYSE:MT) but acts and trades like a preferred stock also.

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MTCN trades on the NYSE like a preferred issue, but it has features that are different from most preferred stocks. It allows the holder to convert each note into 1.19389 common shares at any time between the time of purchase and 1/15/2016. On 1/15/2016 all shares of this issue must be converted to common shares using a formula based on the price of the common for 20 days prior to conversion. (See article written on this issue earlier)

WY-A is a mandatory convertible preferred of Weyerhaeuser Co.(WY).

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In many ways, WY-A is similar to MTCN above, but it is a preferred stock instead of a note. This issue has clauses in it that allow the company to buy back the preferred stock if certain events do not occur. It also allows the holder to convert the issue to 1.5015 common shares at any time prior to 7/01/2016. On 7/01/2016 all outstanding shares of this issue must be converted to common using the price of the common as the basis for the computation.

DCUA is an equity unit of Dominion Resources, Inc.(NYSE:D).

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DCUA is a mandatory convertible security that requires one to either purchase $50.00 worth of common stock or to turn one's unit into common stock. Each unit represents 1/20th undivided beneficial ownership in a $1000.00 subordinated note due 4/01/2021. However, the stock purchase or conversion must take place by 4/01/2016. If one pays for the stock purchase instead of converting the note to stock, the note will be redeemed on 4/01/2021. (At least that is how this author understood it.)

GEAPO is fixed/float preferred stock of General Electric Capital Corp. (GE).

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GEAPO is one of the highest denomination preferred stocks on the exchanges. It is quite unique in that it has a fixed dividend at 5.25% until 6/15/2023. After that date the dividend will become a floating rate that will be equal to the prior 3 month LIBOR plus 2.967% per annum. The company may, at its discretion, redeem the issue after 6/15/2023. This issue may also be called at any time if the federal regulations do not allow GE to consider the capital raised by this issue as Tier 1 capital on its balance sheet.

ELU is the final issue to consider in this article and is a first mortgage bond of Entergy Louisiana, LLC. (NYSE:ETR)

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ELU is a first mortgage bond which means it ranks above a regular preferred stock. It is a secured indebtedness that ranks equal to any other mortgage or senior debt. It also has a maturity date of 6/01/2063 which means that the company is bound to return the call or liquidation price of $25.00 at that time. It may also redeem this preferred issue any time after 6/01/2018.

Conclusion

The main thrust of this article is to show the various kinds of preferred issues available on the stock market and what their provisions mean to the investor. One would be well-advised to take these provisions into account prior to making a purchase. It is important to understand how these provisions might affect one's investment going forward. Finally one should know enough about the issuing corporation to ascertain that it will survive and be able to pay the dividend. The rate of return and various provisions are meaningless if the company goes bankrupt.

There are many preferred stocks available at the moment that are paying over 5% and offer the retired investor a steady cash flow. Hopefully this will help one decide if a particular preferred stock is an opportunity to prosper or a trap for the less discerning.

Source: Know What You Are Buying When You Invest In Preferred Stocks

Additional disclosure: I have holdings in some of the examples listed. However I am not recommending any particular issue in this article. If one sees an issue that looks interesting, I suggest further research.