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Stock Basics

Preferred Stock

A second type of stock, which a company may choose to issue, is preferred stock. Preferred stock is listed separately from common stock and trades at a different price. Unlike common stockholders, preferred stockholders are not usually entitled to voting rights, but they do have a higher claim on assets and earnings than do common shareholders.

While common shareholders are not guaranteed a dividend payment, preferred shareholders enjoy a fairly fixed dividend and are paid before a company decides whether it can pay its common shareholders.

On the other hand, if the company does increasingly well, dividends for preferred shareholders are unlikely to increase as earnings increase, while a common shareholder could benefit from higher dividend payments.

Preferred stock or "preferred securities" share many characteristics of both a stock and a bond. Like bonds, they have a relatively high fixed-rate payment. Like common stock, they are generally listed on a stock exchange. A preferred stock is an equity that may or may not have maturity. A preferred can either pay a dividend or interest, usually quarterly or semi-annually, and it represents a non-voting ownership in a company. These securities are called "preferred" because preferred shareholders have superior rights to assets and cash flows of a company versus common shareholders in the event of a bankruptcy or liquidation; however, bondholders' claims are senior to those of preferred shareholders.

Preferred stocks trade on the NYSE and NASDAQ exchanges and are generally issued at $25 per share. All have the right to delay or defer their dividends under certain conditions. Many preferred stocks are cumulative, meaning if they do defer their dividends, they must make up all missed preferred dividends before any dividend can be paid to common shareholders.

Preferred Stock Features

Cumulative Preferred

If the issuer omits a dividend payment, the payments accumulate and are paid if the issuer can ever resume making dividend payments. All accumulated preferred dividends must be paid by the issuer prior to making a dividend distribution on their common stock.

Callable Preferred

The issuer has the right to call in the shares after a set date, usually at par value. Issuers tend to call in the shares if interest rates have fallen. After retiring the old high rate shares, new preferred shares can be issued at the current lower rates.

Convertible Preferred

The preferred shareholder can convert his shares into the common stock of the issuer based on a predetermined price. If the market price of the common rises, the convertible's perceived value is generally pushed up as well. The security may act more like a bond in its early years, and more like a stock later on. Some convertibles have a mandatory conversion into common stock on a specified date.

Participating Preferred

In addition to the fixed dividend rate, the preferred participates in any "extra" dividends declared by the Board of Directors. For example, if the company has a very strong year, and wishes to reward its common stockholders with a special year-end dividend, the preferred stock as well as the common stock will receive the dividend if the preferred has a participating feature.

Types of Preferred Stocks

Traditional Preferred Securities

The most traditional preferred stock structure is perpetual, meaning that there is no stated maturity. However, issuers can and do retire outstanding preferred stocks through call provisions.

Hybrid Preferred Securities

New types of preferred stocks called "hybrid preferred stocks" or "fixed-rate capital securities" were introduced in 1993. These preferred stocks were created for the individual investor. Hybrids are a combination of debt instruments and preferred shares of equity. They typically have higher liquidation and cash-flow status versus traditional preferred stocks, and hybrids usually pay a higher yield.

Hybrid preferred stocks technically pay interest and not dividends. These payments are paid in "before tax" dollars. The interest payments are fully taxable to all shareholders, and they reduce the cost of paying the dividend to the issuing corporations. Thus, the issuing company can offer higher yielding preferred stocks that actually cost less (by the way of taxes) than comparable yielding old-style preferred stocks.

Some of the hybrids on the market today are MIPS, QUIPS, QUIDS, TOPrS, QUICS and MIDS (see below for acronym explanations).

All investors are advised to understand the characteristics of the security they are purchasing that may affect its value. Be advised that most hybrid preferred stocks do not qualify for the new 15% tax on dividends. Interest income is still taxed at the investor's income tax rate. However, demand for this type of security is still appealing to issuers because of the deductibility of interest. Today, the debt/equity hybrid preferred stocks account for over 75% of the preferred stock marketplace.

Trust Preferred Securities

Preferred stocks issued today are generally "trust preferred stocks," which are hybrid securities consisting of a preferred stock issued by a special trust and a debt security issued by the company. A special trust is a subsidiary of the company set up solely for the purpose of selling and administrating the trust. The trust is sold to investors, and the proceeds are then used to buy debt securities from the company setting up the trust. The debt securities make interest payments that are paid by the company to the trust. These payments are then used to fund the trust's distributions made to the preferred security holders.

Once the debt securities have matured and are paid off, the trust uses those funds to pay off the trust preferred securities, which mature on the same date as the debt security. The company that has issued the trust preferred securities has the option to redeem the trust-preferred securities at the issue price, generally several years from the issue date. If the trust has been called, redemption is mandatory for the holder of the securities.

These debt securities have a deferrable interest clause that allows the company to defer interest for up to five years. The preferred holder is required to pay taxes on the deferred but accruing dividends even though the holder is not receiving any payment. The trust preferred holder is guaranteed to receive the dividend payment if the company pays the interest payment to the trust. The advantage of this hybrid arrangement to the company is that the interest paid on the debt securities is deductible from their income taxes. The traditional preferred dividend was not deductible for the issuer.

Nearly all preferred stocks sold over the past decade are "trust preferred stocks" and are marketed by brokers under such names as QUIPS, SKIS and TOPRS (see below for acronym explanations). These were developed by investment bankers to allow corporations to put preferred equity on their balance sheets and pay for it with tax-deductible interest.

Preferred Stock Structures

All debt/equity hybrid preferred securities share the same basic features. However, there are three basic types of structures that differ primarily as a result of whether the parent company issues the securities directly or through a conduit-financing vehicle:

Preferred Partnership Securities - The conduit issuer is either a limited partnership (LP) or a limited liability company (LLC) organized by the parent company. MIPS and QUIPS are examples of preferred partnership securities.

Trust Preferred/Capital Securities - Issued by a grantor trust established by the parent company. Some examples are SKIS, TruPS and TOPrS.

Junior Subordinated Debentures - Issued through direct obligation of the parent company. Examples are MIDS, QUICS and QUIDS.

Preferred Security Acronyms

The following are a few examples of the many acronyms used to designate preferred securities:

MIPS Monthly Income Preferred Securities

QUIPS Quarterly Income Preferred Securities

QUIDS Quarterly Income Debt Securities

TOPrS Trust Originated Preferred Securities

QUICS Quarterly Income Capital Securities

TruPS Trust Preferred Securities

PINES Public Income Notes

QUIBS Quarterly Interest Bonds

CBTCs Corporate Backed Trust Certificates

CorTS Corporate-backed Trust Securities

TRUCs Trust Certificates

SATURNS Structured Asset Trust Unit Repackaging

CABCO Corporate Asset Backed Corp

Yield to Call

Yield to call (YTC) is an important consideration when making a preferred security purchase. However, the YTC is only meaningful if the security is purchased at today's market price and if it is called away on the next possible call date.

Send an e-mail to support@scottrade.com for the YTC percentage before investing. Please limit your requests to a maximum of five issues at any one time.

Risks

Default Risk

As with any investment, there is default risk. Default is slightly different with preferred stocks. Most preferred stocks can delay paying their dividends/interest without being in default. Typically, this deferral must be preceded by an elimination of the dividend on the common stock. In the case of cumulative preferred stocks, all missed dividends/interest payments must be paid to preferred holders before the common stock dividend is restored.

Market Risk

Prices of preferred stocks change all the time, based on interest rate fluctuations and supply and demand. The price of preferred stocks, like common stock, drop by the amount of the dividend on the ex-dividend date.

Liquidity

Liquidity on listed preferred stocks varies. The more liquid issues may have as little as a few pennies difference between the buy price and the sell price. Some less popular issues may trade with as much as a full dollar difference.

Call Risk

Most preferred stocks are callable. Before buying a preferred, investors should find out the "yield to first call" or "yield to worst" on the preferred they are considering.

Scottrade does not provide tax advice. The material provided is for informational purposes only. Please consult your tax or legal advisor(s) for questions concerning your personal tax or financial situation.

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