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Preferred Securities combine the features and characteristics of both equity and debt securities. Because of the blend of equity and debt characteristics, preferred securities may also be referred to as "hybrids." The key terms and features of preferred securities can vary significantly from one preferred security to another. Investors should carefully consider, among other things, the following: coupon payment terms (including whether the issuer may defer payments and, if deferred, whether such deferred payments are cumulative or non-cumulative), call or other redemption provisions, maturity date (if any) and whether the maturity date may be extended by the issuer, priority ranking in the capital structure of the issuer (which is particularly important in the event of issuer default).
This is not a complete list of all possible features, but it can help you choose preferred securities that are more aligned with your investment needs and goals.
Payment Features – Preferred securities usually make payments in the form of either interest or dividends based on the par (face) value of the security. Typically, the payments have a scheduled frequency of monthly, quarterly or semi-annually, however, whether a preferred security makes a payment is contingent upon the financial condition of the issuer and may also be dependent on conditions or events indicated in the security's offering documents. Some preferred securities allow the issuer to defer or simply skip payments (see Risks for more information.) Payments may be made at fixed, floating or adjustable rates. Certain preferred securities have more complex payment terms. For example, some have a floating or adjustable rate of payment based upon a short or long-term interest rate index (such as the 3-Month LIBOR, which is a widely used daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market or interbank market). Others may begin their lives with a fixed coupon and convert into a floating coupon at some specified date (often referred to as a fixed to floating coupon payment). Such variable or adjustable payment terms may make it difficult for investors to formulate yield expectations.
Maturity Date (the date when principal is generally required to be paid by an issuer) – Preferred securities may have a stated maturity date, however, many are perpetual and do not. Additionally, even if there is a stated maturity date, the issuer may have the option to extend that date one or more times.
Call Features/ Early Redemption – With or without a maturity date, many preferred securities have optional, mandatory and/or conditional early redemption or call provisions which permit the issuer to redeem the securities prior to the stated maturity date (if there is one) or at other times (in the case of no stated maturity date). These types of features can make preferred securities less appropriate for investors looking for regular payments over longer periods of time.
Convertibility – Convertible preferred securities can typically be exchanged for a specified amount of a different security, often the common stock of the issuing company. Convertible preferred securities can combine the fixed income characteristic of bonds with the potential appreciation characteristic of equities. There are often provisions attached to convertible preferred securities which place restrictions on when they can be converted. Additionally, because convertible preferred securities can typically be exchanged for the equity of the issuer, these securities may be susceptible to price fluctuations inherent with the equity markets.
Taxes – Not all income from preferred securities is taxed the same way. Different issues from the same issuer may be structured differently and have different tax consequences. Be sure to read the Taxation section of the preferred security's offering documents to understand how it may be taxed and consult your tax advisor for additional information on how they may impact your tax situation.
Subordination or Priority of Claim in the Event of Issuer Default and Liquidation – The concept of subordination or priority of claim relates to the order in which creditors and investors receive proceeds from the issuer's liquidation or restructuring in the event of issuer failure or default. Generally speaking, preferred securities are senior to common stock, but subordinate to secured bonds in an issuer's capital structure, and therefore, are typically subject to greater credit risk than secured bonds of the same issuer. An Overview of capital structure priority rank is as follows:
1) Secured Debt
2) Senior Unsecured Debt
3) Subordinated Debt
4) Junior Subordinated Debt
5) Hybrid Preferred Securities (such as trust preferred securities, fixed rate capital securities, etc.)
6) Traditional Preferred Stock
7) Common Stock
Yield – Preferred securities may provide more attractive yields than securities which have seniority in payment priority. This is partly to compensate for the increased risk associated with a lower payment priority. Generally speaking, higher yields are a sign of potentially greater risk. There are a variety of yield calculations which can be used when evaluating a preferred security. Current yield is a commonly used yield calculation for traditional preferred securities. It can be calculated by dividing the annual interest or dividend payment amount by the current market price of the security and multiplying the result by 100. For example, a preferred with a $25 par or face value with a fixed coupon rate of 6.5% pays an annual interest or dividend payment of $1.625. If the current market price of the security is $24.25, the current yield would be 6.701% ($1.625 divided by $24.25 times 100).
Yield to call, yield to maturity, and yield to worst are yield calculations more commonly used for preferred securities which are debt or have debt-like attributes. Yield to maturity is the rate of return anticipated on a security if it is held to maturity date. The calculation of yield to maturity takes into account the current market price, par value, coupon rate and time to maturity. It assumes that all coupon payments are reinvested at the same rate. Yield to call is the yield on a security assuming it will be redeemed by the issuer on a specified call date. The calculation of yield to call takes into account the current market price, call price, coupon rate and the length of time to the call date. Yield to worst refers to the lowest potential yield anticipated on a security. A Price/Yield calculator is available on the Research > Fixed Income section of Fidelity.com and may be helpful to customers when calculating yield to maturity or yield to call for preferred securities.
This is not a complete list of the investment risks of preferred securities, but it explains some of the most common ones you may encounter. You should read a preferred security's offering documents for more details about its specific features and risks
Interest Rate Risk – When interest rates rise, the prices of existing preferred securities typically fall. The effect is usually more pronounced for longer-term securities.
Credit and Default Risks – Credit risk is the risk that the issuer of or the counter-party to a preferred security will default or be unable to meet its financial obligations. Generally, credit and default risks are higher for lower-rated securities
Call Risk – Many preferred securities carry call or other early redemption provisions that allow the issuer to redeem the security upon certain events or at its discretion. An issuer will often exercise a call provision when prevailing interest rates drop below the rate at which the security was originally issued. Many preferred securities include a conditional call option, allowing the issuer to redeem the securities at the liquidation value upon the occurrence of certain events (e.g. tax law changes disallows the deductibility of payments by the issuer's parent company, or subjects the issue to taxation separate from the parent company).
Market Risk – Preferred securities are subject to market volatility and price fluctuation due to events affecting the issuer or the overall market.
Liquidity Risk – Liquidity refers to ease with which you are able to buy and sell a security to other investors. Certain preferred securities may not be able to be readily redeemed (liquidated) or may only be liquidated at a deep discount to par (face) value due to a limited secondary market for the securities.
Payment Deferral Risk – Many preferred securities carry a payment deferral feature, which allows the issuer, at its discretion, to suspend or defer all or a portion of dividend or interest payments. Payments, if suspended or deferred, may be cumulative or non-cumulative. In the case of non-cumulative preferred securities, deferred payments due not accumulate if unpaid, and the issuer is under no obligation to pay the missed payments in the future. If payments are deferred, usually the company is also no longer permitted to pay dividends on other securities ranked either equally, or lower, in the hierarchy of the company's capital structure. As a result, holders of noncumulative securities carry a greater potential risk of losing an important source of total return, whereas cumulative preferred shareholders may be able recoup lost income if a company is able to return to financial health and make up the missed payments.
Maturity Extension Risk – Certain preferred securities permit the issuer, at its discretion, to extend the maturity date (if any) one or more times, which would ultimately delay final repayment of the security's principal.
Inflation Risk – Preferred securities are subject to the risk of inflation reducing the purchasing power of future payments of interest, dividends or principal. Inflation rates may often be correlated with interest rates, but they are separate and distinct risks.
A share of common stock represents an ownership stake in a company and usually has voting rights. If a company grows, or realizes a profit, those who own common stock in the company may receive a dividend or the share price of the common stock may climb. Conversely, if a company does not perform well, those who own common stock may not receive a dividend or the stock's share price may fall. If the company goes bankrupt, those who own common stock may lose their investment entirely, as their claims against the company's assets are generally unsecured with no priority
Preferred securities represent a class of ownership in a company that has a higher claim than common stock shares on the company's assets and earnings; however their claim is generally below that of the company's bond holders. Generally, preferred security shareholders do not have voting rights. Preferred securities can be thought of as a hybrid of common stocks s and bonds, as the holder of a share of preferred security is normally paid income which receives priority over dividend payments to common stock shareholders. However, if the company grows, or realizes a profit, the share price of a preferred security generally increases more slowly than the share price of the company's common stock. In the event of a bankruptcy, holders of preferred securities have priority claim to the company's assets over holders of common stock, although the preferred security holder's claim is still subordinate to that of most bondholders.
In essence, in exchange for potentially higher interest or dividend income and a higher priority of claim in the event of a company's liquidation, holders of preferred securities forgo any common stock dividends and the potentially larger future capital appreciation associated with commons stock. Though capital gain opportunities for preferred securities holders can occur during periods of declining interest rates and improved credit conditions, historically most investment returns from preferred securities comes from their periodic income distributions.