Callable Preferred Stock Definition
Callable preferred stock is the stock where the issuer of such stock enjoys the right to repurchase such issued stock after the pre-decided date at a specific price mentioned in the terms of prospectus while issuing stock and such price cannot be changed later at any time or at the time of redemption.
In simple terms, callable Preferred Stock is a type of preferred stock that gives the issuer the right to call or redeem the stock at a pre-set price after a pre-determined date. Also known as callable preferred shares, it is a popular means for financing large-scale organizations as it uses a combination of debt and equity financing. Such shares may also be traded on the stock markets as well.
How Callable Preferred Stock Works?
Company ‘R’ issued preferred stock in 2005, paying 12% rate and maturing in 2025 and also callable in 2015 at 103% of par value. Ten years from the issue, ‘R’ gains the right to call the stock, which it may consider if the interest rates in 2015 fall below 12%.
Generally, the issuer must pay the investor more than the par value of the stock for calling the issue. This difference is termed as ‘Call Premium’ and this amount typically decreases as the preferred stock is coming close to maturity. Say Company ‘R’ will offer the stock at 103% of face value if the call is issued in 2015 but it may offer only 102% if called in 2020.
Features of Callable Preferred Stock
There are some important features of such stocks:
- Owners bear the risk of being called back and the strike-price premium is meant to compensate the holder for certain or all of the risks.
- These stocks certainly pay a dividend regularly to keep the shareholders attracted. However, it can be challenging for investors who depend on the same as a source of income.
- It should be noted that the price of callable preferred stock is impacted by whether the call is in-the-money, out of the money or at the money.
- In terms of dividend and liquidation, they get preference over the common stockholders.
- These stocks can be issued as Cumulative, Participating, Callable, and Convertible.
Benefits
- Since the shares can be repurchased after the call date, issuers can permanently avoid a situation of giving up a majority interest in the company. This aspect can give them an upper hand during crisis situations.
- Voting control can be maintained as preferred shares are classified as non-voting shares.
- The funding costs can be kept under control.
- Common shares can be made available for equity incentive plans.
- The call price for repurchasing of the shares at the time of prospectus execution. This allows organizations to strategize the timing of call when they have surplus cash with them.
Drawbacks
- Investors may be unwilling to pay as much as equity subject to call.
- The perceived value of the callable preferred stock is unlikely to be higher since they have less potential for the upswing. Therefore, investors who are anticipating a bullish market/stock must cash in on such shares before the issuer announces a call. A call announcement generally plummets the share value towards the par value. It sends a signal that there could be some issues in the management and such a step is required to be taken.
- Another angle highlights the ‘call price premiums’ which guarantee a return even if the market is underperforming. This may be a costly option but investors should consider such options if their investment objective involves consistent returns.
- The addition of security classes can complicate the corporate structure which further imposes compliance costs. This can further expose loopholes in the funding structure.
- Dividends to the common shareholders will not be considered unless preferred shareholder dividends are paid incomplete. Callable preferred stock can generally be a problem if you offer high dividend rates for preferred stock shareholders.
- If the call price turns out to be lower than the existing market price, the investor loses part or entire capital gains if the firm decides to call the shares.
Conclusion
The option of a callable preferred stock shall be considered if the organization is currently exploring financing options for a new unit/firm and desire to avoid the complexities in equity and debt financing. Though the procedure of repurchasing the shares is easy as the conditions are laid down during inception and only notice must be sent to the relevant shareholders with essential details. However, since premium has to be offered at the time of the call, issuers must ensure they have sufficient cash balance with them which could be at the cost of other opportunities to the firm. Such a step also has an impact on the share price and put a cap on the same. Thus, all these aspects must be considered before arriving at any decision.
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