Callable Preferred Stock Definition How Does It Work

Callable Preferred Stock Definition

In simple terms, callable Preferred Stock is a type of preferred stockType Of Preferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more 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 of large-scale financing organizations as it combines debt and equity financing. Such shares may also be traded on the stock markets.

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How does Callable Preferred Stock Works?

Company ‘R’ issued preferred stock in 2005, paying a 12% rate and maturing in 2025 and also callable in 2015 at 103% of par value. Ten years after 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 stock’s par valuePar Value Of The StockPar value of shares is the minimum share value determined by the company issuing such shares to the public. Companies will not sell such shares to the public for less than the decided value.read more for calling the issue. This difference is called ‘Call Premium,’ and this amount typically decreases as the preferred stock is coming to maturity. Say Company ‘R’ will offer the stock at 103% of face value if the call was 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. The strike-price premium compensates 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 source of income.One should note that the price of callable preferred stock is impacted by whether the call is in-the-money, out of the money, or at the moneyAt The MoneyATM refers to a situation in which the option holder’s exercise of the option results in no loss or gain since the exercise price or strike price is equal to the current spot price of the underlying security. read more;In terms of dividend and liquidation, they get preference over the common stockholdersThe Common StockholdersA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company’s owners, but their liability is limited to the value of their shares.read more.These stocks are an issued as Cumulative, Participating, Callable, and Convertible;

Benefits

Since the shares can be repurchasedShares Can Be RepurchasedShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more after the call date, issuers can permanently avoid giving up a majority interest in the company. This aspect can give them an upper hand during crises.Voting control can be maintained as preferred shares are classified as non-voting shares.The funding costs can be kept under control.Common sharesCommon SharesCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity.read more can be made available for equity incentive plans.The call priceCall PriceA call price (CP) is the amount an issuer pays the buyer to buyback, call, or redeem a callable security before it matures.read more for repurchasing the shares at the prospectus execution allows organizations to strategize the timing of the call when they have surplus cash with them.

Drawbacks

Investors may be unwilling to pay as much as equity is 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 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 signals 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. It may be costly, but investors should consider such options if their investment objective involves consistent returns.The addition of security classes can complicate the corporate structure, further imposing compliance costs. It can further expose loopholes in the funding structure.Callable preferred stock can generally be a problem if you offer high dividend rates for preferred stock shareholders. Dividends to the common shareholders will not be considered unless preferred shareholder dividends are paid in complete.If the call price turns out to be lower than the current market price, the investor loses part or entire capital gains if the firm decides to call the shares.

Conclusion

Though the procedure of repurchasing the shares is easy as the conditions are laid down during inception, only notice must be sent to the relevant shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more with essential details. The option of a callable preferred stock shall be considered if the organization is currently exploring financing options for a new unit/firm and desires to avoid the complexities in equity and debt financing. However, since a premium has to be offered at the time of the call, issuers must ensure they have a sufficient cash balance, which could be at the cost of other opportunities for the firm. Such a step also impacts the share price and puts a cap on the same. Thus, all these aspects must be considered before arriving at any decision.