Preferred Stocks & Convertibles Topic 8 I. Preferred Stocks 1

A. Characteristics 1. Hybrid Securities – a. Pay DividendsCS – b. Equity OwnershipCS – c. Prior ClaimBond – d. Fixed DividendsBond 2

A. Characteristics (continued) 2. Advantages / Disadvantages – a. High Current Income – b. Safety – c. Low Unit Cost ($10-$25/Share) – d. Inflation -- not a good hedge – e. Lacks capital gain potential 3

A. Characteristics (continued) 3. Sources of Value – a. Dividend Yield P = D / K D = Dividend K = Required Return 4

B. Usual Features of Preferred Stock 1. Voting – Usually nonvoting but does have contingent voting rights. This is the right to elect some of the directors. – Usually have the right to vote for approval on the issuance of additional Preferred Stock. 2. Maturity and Call – Typically Preferred Stock has no maturity date (like C/S). – The typical Preferred is callable. 5

B. Usual Features of Preferred Stock (continued) 3. Sinking Fund – 40% of Preferred issues have this agreement, usually found in public utility Preferred 4. Dividends – Cumulative VS Noncumulative 5. Convertibility – Preferred is typically nonconvertible – 1/3 of Preferred are convertible 6

C. Yields 1. Compared with Bonds, Preferred are typically higher. Why? 2. Pattern – Similar to Bonds 3. Yields have tended to be relatively unstable. This suggests a higher degree of risk. 7

D. Analysis of Preferred Stock 1. Assets/Share – Example: Assume: TA = $110TD = $50 1 million Preferred Shares with $10 par – The “Net Asset/Share” would be $60 million = $60/Share 1 million shares – This would cover Par 6 x 8

D. Analysis of Preferred Stock (continued) 2. Preferred Stock Ratings – S&P Rating : AAA to C 9

E. Preferred Stock as an Investment 1. Better suited for the Institution 2. Does not share in earnings 3. Does not have the security of Bonds, more volatile 4. Only becomes attractive when the yield is greater than Bonds 10

Preferred Stocks & Convertibles Topic 8 II. Convertible Securities 11

A. Characteristics 1. Hybrid possessing the features and performance qualities of both fixed income and equity securities 2. Should be viewed primarily as a form of equity 3. Provide the “Equity Kicker” 4. A “Deferred Equity” 12

B. Convertible Bonds 1. Issued as Debentures 2. Over time, may be converted into a certain number of shares 3. Normally “Freely Callable” which may lead to “Forced Conversion” 13

B. Convertible Bonds (continued) 4. Options at forced conversion – Convert to shares – Redeem the Bond for cash at the stipulated call price 5. Conversion Privilege – Stipulates the conditions and nature of the conversion – Initial waiting period of 6 months to 2 years – Conversion period may have a limited life 14

B. Convertible Bonds (continued) 6. Conversion Ratio – Number of common shares which the Bond may be converted into – Example: A Ratio of 20 states that a $1000 Bond may be converted into 20 shares of the Common Implied conversion price is $50/Share Ratios are normally fixed but can be variable Ratios are adjusted for stock splits 15

C. Sources of Value of Convertibles 1. Convertible Securities trade like a Common Stock. They derive value from the Common Stock. – Example: Assume a Convertible has a ratio of 20 and the Stock sells for $45. If the conversion price is $50 ($1000/20), then for every point the stock goes up or down the Convertible Security will move by 20x. – Hence, Price of Convertible Security in example is: $45 * 20 = $900 16

D. Risk 1. Risk is a function of the issue’s fixed income and equity characteristics. 2. Fixed income nature defines its floor price. 3. Equity nature defines its ceiling price. 17