Preferred and Derivatives
Preferred shares are fixed income securities. Whereas common share dividends are tied to the earnings of the issuing company, preferred shares entitle the holder to a fixed dividend income. Preferred dividends are not a legal obligation of the company and can therefore be omitted. Most preferred dividends are cumulative, however, meaning that unpaid dividends accumulate and the company is prohibited from paying dividends on its common shares until the arrears have been paid in full.
Preferred shares have a prior claim to assets over common shares in the event of a company’s liquidation, dissolution or winding-up. The extent of this claim is limited to a specific dollar amount which is generally at or above par (depending on whether liquidation is voluntary or involuntary). The claim of preferred shares to assets is however subordinate to the claims of creditors and debtholders.
While almost all preferred shares are non-voting, most issues provide for limited voting rights when dividend payments are in arrears and some give shareholders the right to vote, as a class, to elect one or more directors to the board. Redemption features give the company the right to call, on notice, preferred shares for redemption at a premium over paid-up value. The premium required on redemption usually reduces to nothing over time. On redemption, the company must also pay all dividend arrears and all dividends which have accrued to the date of redemption. Purchase obligations are another standard feature of preferred share issues. They require the company to purchase for cancellation, in the open market a specified number of shares each year, at or below a stated price, if available. Purchase obligations can be either cumulative or non-cumulative.
In addition to these basic features, a number of sweeteners such as conversion and retraction privileges and floating rate dividends can be incorporated into an issue to make preferred shares even more appealing from the investor’s point of view. Instead of paying fixed-rate dividends, the issuer can elect to pay dividends at variable or floating rates which are tied to prime lending rates. Floating rate dividends provide an obvious benefit to shareholders in times of rising interest rates. Most floating rate issues offer the protection of a minimum dividend rate, should interest rates fall.
Conversion privileges give shareholders the option of exchanging preferred shares for another class of shares (usually common) at a specified price or conversion rate during a specified time period. The value of the conversion feature depends upon the length of the conversion period and the value of the underlying shares.
Retraction privileges allow the shareholder to force redemption of the preferred shares on a specified date at a specified price. Retractable preferred share issues can carry multiple retraction privileges and frequently contain provisions which allow for the introduction of new conversion features or increased dividend rates, on or about the retraction date.
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