Preferred Stocks & Convertibles Topic 8 I. Preferred Stocks

A. Characteristics n 1. Hybrid Securities a. Pay DividendsCSa. Pay DividendsCS b. Equity OwnershipCSb. Equity OwnershipCS c. Prior ClaimBondc. Prior ClaimBond d. Fixed DividendsBondd. Fixed DividendsBond

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

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

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

B. Usual Features of Preferred Stock (continued) n 3. Sinking Fund 40% of Preferred issues have this agreement, usually found in public utility Preferred.40% of Preferred issues have this agreement, usually found in public utility Preferred. n 4. Dividends Cumulative VS NoncumulativeCumulative VS Noncumulative n 5. Convertibility Preferred is typically nonconvertiblePreferred is typically nonconvertible 1/3 of Preferred are convertible1/3 of Preferred are convertible

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

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

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

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

Investing in Preferreds n Most new-issue preferreds come with five year call protection, meaning the issuing corporation cannot call your preferred away from you for a full five years. After five years, it’s open season. If interest rates have declined and the price of preferreds has risen, you can expect a call. Issuing corporations will want to replace older, higher-yielding preferreds with new lower-yielding preferreds. During the five year period, the typical preferred will go up in value around the third year and then begin to decline. Therefore in an environment of stable of decreasing interest rates, you will always get this peak and roll process.

Investing in Preferreds n The Peak and Roll of Preferreds: Preferreds today promise 8% to 9%. These are NYSE listed blue-chip securities. In order to cash in on preferreds, you need to understand the concept of peak and roll. Let’s say that over three years of a preferred’s existence, its price has risen to $27/share from it’s original offering price of $25. The price of the preferred has risen because interest rates have declined. If the preferred is callable at five years, at some point between year three and year five, the price of the preferred will peak and begin to roll down back toward $25. Don’t hang around for the complete peak and roll. When the stock hits a peak sell and buy a new five year preferred. Your return is then 9% + 2.6% from the $2.

Preferred Stocks & Convertibles Topic 8 II. Convertible Securities

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

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

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

B. Convertible Bonds (continued) n 6. Conversion Ratio Number of common shares which the Bond may be converted intoNumber 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 CommonExample: 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

C. Sources of Value of Convertibles n 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.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 = $900Hence, Price of Convertible Security in example is: $45 * 20 = $900

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