Adjustable Rate Preferred Stock - Explained
What is Adjustable Rate Preferred Stock?
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Table of ContentsWhat is Adjustable-Rate Preferred Stock?How is Adjustable-Rate Preferred Stock Used? Boundaries in PlaceAcademic Research on Adjustable-Rate Preferred Stock ARPS
What is Adjustable-Rate Preferred Stock?
Adjustable-Rate Preferred Stock is a form of preferred stock where the dividend paid will have variations with a benchmark rate, generally that of a T-bill. The valuation of dividend from preferred shares is ascertained beforehand with a formula so as to be flexible with rates, and due to this flexibility, prices are usually more consistent in nature than fixed-rate preferred stocks.
How is Adjustable-Rate Preferred Stock Used?
When the company liquidates, preferred shareholders are given preference of receiving dividends, thereby making the preferred stocks safer and more reliable. Also, the restriction on the change of rate of dividend adds more cushion to the issue. Besides, the dividends of ARPS can be adjusted to match the existing rates of interest, or other rates of interest prevailing in the money market. This generally takes place every quarter. Consistent dividend payouts coupled with the consistency in market value offered by adjustable-rate preferred stock add another advantage for investors seeking fixed and stable returns, and the protection of their capital. Adjustable preferred-stocks have similar advantages and disadvantages to offer similar to fixed-rate preferred stocks. During the liquidation process, the companies tend to pay dividends to preferred stockholders before making dividend payments to common stockholders. However, there are a few differences between adjustable preferred stock and non-adjustable stock. The rates of adjustable preferred stock dividends are associated with a standard index or reference rate. With the decrease of reference interest rate, the dividend rate of adjusted preferred stock falls as well. As a result, the investors end up receiving lesser dividends, and there are less or almost no changes in stock price with these securities in contrast to fixed-rate preferred stocks where stock prices have an inverse relationship with interest rates.
Boundaries in Place
Adjustable preferred stocks consist of fixed standards called collars. These primarily consist of caps and floors positioned on dividend yields. A floor represents the minimal amount of dividend that adjustable preferred stockholders would receive, no matter if rates of interest fall below the floor rates. As opposed to floor, a cap sets the maximum yield that stockholders will receive as dividend, and this naturally can be an unpleasant factor for investors. APS work just like fixed-rate preferred stocks when interest rates drop on the other side of collar limit. Many adjustable preferred stocks consider timely auctions for revising dividend yield. The participants of yield consist of both existing and prospective shareholders, and the APS dividend yields are based on investors current objectives.
Academic Research on Adjustable-Rate Preferred Stock ARPS
- Dutch auction rate preferred stock, Alderson, M. J., Brown, K. C., & Lummer, S. L. (1987). Dutch auction rate preferred stock. Financial Management, 68-73. Corporate cash managers have developed a number of equity-based strategies designed to utilize the partial tax exclusion for dividend income. A problem that has been common to all of these investment programs, to various degrees, is the need to protect invested principal. This paper examines a recent innovation in the area of corporate finance and cash management, dutch auction rate preferred stock (DARPS). Specifically, a sample of 201 dutch auction outcomes is empirically examined. The results demonstrate that DARPS issues provide a superior after-tax return relative to commercial paper and Treasury bills. Further, yields are shown to be set such that the tax benefits of the dividend exclusion are shared between the issuing and purchasing firms.
- New Developments in Financial Management Adjustable Rate Preferred Stock, Winger, B. J., Chen, C. R., Martin, J. D., & Petty, J. W. (1986). New Developments in Financial Management Adjustable Rate Preferred Stock. Financial Management (1986), 15(1), 48.
- Preferred stock arbitrage of municipal bond market segmentation, Elmer, P. J. (1986). Preferred stock arbitrage of municipal bond market segmentation. Financial Review, 21(4), 383-398. This paper discusses how tax and regulatory constraints in the municipal bond market can affect preferred stock yields and give rise to arbitrage opportunities in the preferred stock market. The potential for profit is illustrated with an example that also serves to highlight the unique characteristics of recently developed forms of preferred stock.
- Adjustable Rate Preferred Stock, Thies, C. F. Adjustable Rate Preferred Stock. The introduction and continuing innovation of adjustable rate preferred stock is discussed in light of institutional, regulatory and tax considerations. The observe volatility in the market prices of these securities is explained by the caps on their dividend re-set formulas and by the changing credit-worthiness of their issuers. An econometric model is developed which explains 76 percent of the variation in the market prices of seasoned issues and which is reasonably stable across time and across issuers.
- HEDGING FIXEDRATE PREFERRED STOCK INVESTMENTS, Murphy, A. (2001). HEDGING FIXEDRATE PREFERRED STOCK INVESTMENTS. Journal of Applied Corporate Finance, 14(1), 80-89. Corporations seeking to maximize the return on their cash reserve resources have an incentive to invest in traditional preferred stock because of their right to exclude 70% of the dividends from taxation. Nevertheless, fixedrate preferred stock investments may contribute significantly to the return volatility of a cash portfolio and cause unacceptable losses to the corporate investors. As a result, many corporations might consider such higherreturn investments only if they can hedge away a sufficient amount of risk. The research presented in this article seeks to evaluate how much of the return variation of fixedrate preferred equity portfolios can be reduced with various hedging strategies. This research shows that it is possible to reduce the risk of preferred stock investments significantly through the use of hedges employing some combination of fixed income futures and/or options. Although some risk remains even with the hedged preferred stock portfolio, the author demonstrates that money market assets can be combined with a hedged preferred stock portfolio to create a position that has no material chance of loss but expected aftertax returns higher than those on money market investments. In addition, the article also shows the high level of profitability associated with a strategy of increasing the size of liquid reserves in order to allow for losses related to an unhedged preferred stock component of those reserves.