Par and Preferred Stock

Hey guys, welcome back to another SIE exam prep article. Today we're discussing par and preferred shares. You can check out the full podcast on Spotify or Apple Podcasts. Additionally, I just finished writing up both sections over at my SIE course. I'd love it if you were able to check it out. If not, hopefully the following podcast and transcript are helpful.

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Episode Two Transcript

Introduction

Hey, what's going on guys. Welcome back to another episode of the FINRA Ninja, the podcast bringing you curated SIE exam prep. Today we're discussing preferred stocks and par. No, not like the golf swing. We're talking the face value of issued securities. With that, let's dive right in.

Par

To understand concepts like a security's yield, we first have to understand par. Par, sometimes called the nominal value, is simply the face value of an issued security. This means it's what the issuer of a security originally sells it for. Additionally, for fixed-income securities, like bonds, it's the price that an issuer will pay an investor when the security matures. It's not related to a security's market value. Once issued, a security's par never changes, but its market price can. We'll take a look at how and why in bit.

Par + Stocks

Par doesn't just affect fixed-income securities, like preferred stocks and bonds. It also, to some small degree, affects equity securities like common stock. Common stock typically has an extremely low or no par amount. As a good example, if you take a look at Apple's 10-K filing with the SEC, a document that outlines a company's annual performance, you can see that Apple stock is set at one hundred thousandth of a dollar. That's 0.00001 dollars.

Why such a low amount? Well, this isn't testable on the SIE, but it's because certain states mandate equities have a par value. Additionally, the security may not be sold for less than that par amount. So in order to comply with some of these laws, issuers set a par value that's impossibly low. Apple below a dollar?

Par + Fixed-Income

Par becomes much more important when we discuss fixed income securities, like bonds. Like stocks, issuers set the par value at the time of issue. For bonds, par value is usually one thousand dollars. Preferred stock is usually $100. These amounts are what the issuer promises to repay the investor at maturity.

For example, if Apple decides to sell a $1,000 par bond that matures in 30 years, I will pay $1,000 for it now, and Apple will give me back my $1,000 30 years from now. Sounds like a terrible deal, doesn't it? That's because bonds are issued with a coupon rate.

Coupon Rate

The coupon rate, also called the nominal rate, is the annual interest rate paid by a bond issuer on the bond’s face value. It's expressed as a percentage of the par value of the bond. Going back to the Apple example, if that 30-year bond, at a par of $1,000, paid $50 a year in interest, then the coupon rate would be 5%. That's $50 of annual interest divided by the par of $1,000.

Let's try a quick example to see if you get it. My company, Ninja Tractors, is issuing a security that pays $3 a year at $100 par. What's the coupon rate? I'll give you a second.

If you said 3%, you'd be correct. We take the annual payment amount, divide it by par, and express it as a percentage. 100 into 3 is 3%.

It's important to note that par value is not the same at the market price. The market price could be lower, the same as, or higher than par. Consider a $100 par security with a 5% coupon rate issued during a time where interest rates hover around 5%. In this environment, the bond allows an investor to keep up with inflation, but not much else. 

However, if interest rates rise significantly, say to 10%, that security is no longer keeping up with inflation. In fact, keeping your money in that security is forcing you to lose purchasing power in the market. Furthermore, the same company that issued the 5% bond is issuing another series at 10% – at the same price! As a result, investors don't have much interest in purchasing the lower coupon bond.

That is, unless the market price drops. If the market price drops below par, it's known as trading at a discount. This can be quite profitable to the keen investor. Looking at an extreme, would you purchase a $100 par bond with a 5% coupon rate for $1? Of course you would! That's a 5 X return on your money, even if it is only $5 a year.

Current Yield

While no investor would actually sell at this price, it shows that at some point, purchasing this investment is a good move. To quantify this, we need to look at the current yield. While the coupon rate only looked at the annual income over par, the current yield factors in the market price of a security.

The formula is simple. It's simply the total annual income provided by a security divided by the current market price of a security. Going back to our extreme example, that would be $5, the annual interest, divided by $1, the price we paid. That's 500%!

In a more realistic scenario, that security might trade at something like $80 if interest rates rise. At $80, the current yield would be 6.25%, or $5 over $80. For either price, we're buying the security at a discount. It's also important to understand that securities that trade at a discount always have a higher yield than the coupon rate. It just can't work out mathematically otherwise.

Now let's consider the opposite. The Fed ropes in inflation, the US rejoices, flippers buy tons of houses, businesses take out huge loans, and everyone is happy. If you bought that 5% coupon bond, you might also be happy. Why? Well, now that money is cheap to borrow, no one issuing securities with that high of a coupon rate. In fact, you're lucky if you see someone offering 2%.

Now, other investors are hungry for higher returns, like the 5% security you purchased. As a result, they're willing to pay more for it. Thus, the market price rises. Then the market price trades above par, it's trading a premium.

What would the current yield be for that 5% security at $100 par, trading for $125? We use the same formula before, annual interest over market value. That's $5 over $125, or 4%. It's not quite the 5% that the original investor got, but it's potentially better than anything else in the market. 

Securities that trade at a premium always have lower current yield than the coupon rate. Again, it just can't mathematically work out otherwise.

Finally, if we consider a security trading in the market for the same price as par, we simply say it's trading at par.

Recap

So let's recap quickly before we move on. Par is the face value of a security. For fixed-income securities, it's what an investor pays an issuer at the time of offering. At redemption, it's what the issuer will pay the investor. Par value and the annual income amount determine the coupon or nominal rate. The market price for a security and the coupon rate determine the current yield.

Preferred Stock

Now that we've covered par, we can cover an equity security that has some qualities that make it like a fixed-income security. That's right, we're talking about preferred stock. Preferred stock is similar to common stock in that it still represents part equity, and therefor ownership of the company. However, unlike common stock, preferred shares don't afford voting rights. That means you cannot use them to vote at shareholder meetings or via proxy.

Features

What makes preferred shares attractive to investors is that they behave like fixed-income securities. They pay dividends on their shares. Well, I should say that preferred shareholders have a preference for dividends. While every preferred stock is issued with a dividend yield, dividends aren't guaranteed. Companies can't pay out money they don't have, after all. 

However, preferred shareholders must be paid before any common shareholders receive dividends. Skipping dividends on preferred stock is generally a bad look for an issuer, so in practice it doesn't happen often. 

The third key features you should be aware of with preferred stock is how it's treated in liquidation. When a company goes under, it must sell its assets to pay back wages, debts, and shareholders. There's an accepted ladder of priorities, set in part by the US Bankruptcy Code, for how different entities and individuals get paid back. Common shareholders are at the very bottom of this list to get their money back – and they frequently don’t.

Preferred stockholders sit just ahead of common shareholders on this list. Every preferred share must be paid out before a single common stockholder is paid back. We won't go in depth to the full priority list here, but generally speaking, the order goes: preferred creditors like company employee wages and the IRS, secured creditors like mortgages, priority unsecured creditors, general unsecured creditors, preferred shareholders, and common shareholders. 

To recap, the three key features of preferred shares you need to know before we move on are: 1, they receive dividend preference; 2, they maintain priority over common stock during liquidation; and 3, they are not afforded voting rights.

Okay, so now let's get into the nitty gritty. We talked about dividend payments, but there's actually two ways those can be implemented. It really only matters if a company happens to skip a dividend payment, but it's super important to understanding an investor's risk. Issuers can have either a cumulative or a non-cumulative payment structure.

Types of Dividend Payments

Cumulative

Under a cumulative payment structure, any unpaid dividends accumulate over time. The issuer must then pay the dividends when they're able to, but certainly before any common shareholders are paid dividends. This is less risky to the investor, as they'll likely get their money at some point. As a result of less risk, preferred shares under this structure have lower yields, lower dividend rates, and higher prices.

Non-Cumulative

So in contrast to the cumulative structure, there's non-cumulative or straight. You may hear either term used for this structure. You may have guessed that, with the non in front of it's name, non-cumulative means the opposite of cumulative. And you'd be right! Non-cumulative rights mean that the issuer just skips dividend payments. They don't accumulate and investors have no right to them later.

Preferred shareholders still have dividend preference and must be paid before common shareholders. Non-cumulative rights are a little more risky than cumulative because they're a serious risk that investors could miss out on dividend payments and never see a return. To compensate for this risk, issuers must issue these with higher dividend rates. As a result, they also tend to carry higher yields and lower market prices.

Additional Features

Okay, so all preferred shares have the features we just talked about. There are some other, optional additional features to make your life more complicated. But don't worry, we'll break it down nice and simple.

Convertible Preferred Shares

The first optional feature is called a convertible right, or a convertible preferred share. These rights allow a shareholders to convert their preferred shared, determined by a conversion ratio, into a set number of common shares. Another way to put this is that an issuer will accept your preferred share and give you a set number of common shares in return.

Issues set a conversion ratio at the time of issue depending on market conditions. For instance, it would make no sense for a company to issue preferred shares, priced at $100 with a 5:1 ratio (that is, one preferred for 1 preferred share) when common shares trade at $50. With that ratio, an investor could immediately purchase a preferred share and convert it into a common share to profit $150. 

Convertible features are beneficial to investors because they provide capital appreciation. If the price of common shares rise dramatically, it could be profitable for an investor to convert their shares for common stock and sell those on the market. Since it's beneficial to investors, you should expect lower yields and higher prices on these types of shares.

One thing to note is that issuing preferred shares is a dilutive action for other common shareholders. This is because preferred shares can be exchanged for common shares. As with any dilutive action, shareholders must first approve their issuance. However, it's still up to the board of directors to determine the yield on the issue, the conversion ratio, and they approve each individual dividend payment. Remember, they're not always guaranteed.

Participating Preferred Shares

Moving on, let's talk about participating shares. Participating shares are likewise advantageous to investors. In addition to fixed dividend yields, participating shares are eligible for additional dividends if the company performs well. For example, if an investor purchased a 10% $100 par participating share, the issuer may elect to pay an additional percentage, say an additional 2%, if they exceeded market expectations. That's it. Short and simple, participating shares just pay additional optional dividends.

Because they're beneficial to investors, they again carry lower fixed dividend rates.

Callable Preferred Shares

At a contrast to the two optional features we just discussed, callable shares take the opposite approach and offer a feature beneficial to the company. The issuer may call back (also called redeeming) any callable shares that an investor holds. The investor does isn't left with nothing, however. The issuer agrees to pay the par value (or sometimes more) in return for redeeming the share.

To see how this is beneficial for the issuer, let's assume an example. An issuer sells a 10% callable preferred share at $100 par. That is, the company agrees to pay the investor $10 a year for each share until the share is redeemed. After issuance, let's say the Federal Reserve significantly cuts rates. As a result, borrowing money becomes cheaper and yields for securities fall significantly. The issuer can now redeem the callable shares to stop paying a 10% yield, which is historically pretty high.

The company can now either retire those shares and stop paying dividends period, or they could reissue shares with a much lower yield, such as 3%. Either way, the company is no longer obligated to pay a high 10% yield. This is bad for the investor because they'd much rather receive a 10% yield than 3%.

Because of this rather significant redemption risk, issuers often sweeten the deal by offering a call premium and call protection. Call premium refers to the amount over par that an issuer agrees to pay an investor for redeeming a share. Call protection refers to the duration of time before an issuer may redeem a share. An example would be a 10% callable preferred stock issued at $100 par, callable for $105 after 2 years.

In this example, the call premium is $5 which is the amount over par. The call protection is 2 years. That is, an issuer cannot redeem a share before the second year. These make the offering more attractive to investors, as they'll receive a 10% yield for at least two years. After the second year, if their shares are redeemed, they'll receive more than the initial investment was purchased for.

Conclusion

So, that's it. I hope you learned a lot about the meaning of par value and the features of preferred shares. As a recap, let's just cover some of the highlights. Par is the face value for a security. This is usually $100 for preferred shares and $1,000 for bonds. Preferred shares are different from common shares. Their three key features include dividend preference, priority in liquidation, and lack of voting rights. 

Dividends may be paid either cumulative, meaning any skipped dividends are eventually paid, or non-cumulative, meaning that investors don't ever see skipped dividends. Finally, we have our three optional features used to either sweeten the deal for investors or protect issues. We have convertible, where we can trade our preferred shares for common shares. Participating, which gives investors an additional dividend if a company performs well. And callable, where an issuer can redeem a share for par. These also optionally have a call premium and call protection. The premium is the amount over par an issuer will pay an investor, and protection is the length of time before an issue can be redeemed.

I hope that you enjoyed this episode of the FINRA Ninja. If you haven't already, check out the blog and course at www.finraninja.com. Through August 14th, 2024, I'm offering free access to my course with the coupon code, all caps, no spaces, THENINJAWAY. I love finance and helping others succeed, so if you have any thoughts on how I can improve, you can reach out to me on the blog. Until next time.