Companies may issue preferred stocks for a variety of reasons. The three reasons below are the most common.
- Preferred stock issuances give companies a relatively cheap way to acquire additional capital. The preferred market is dominated by banks and related financial institutions, which are required by regulators to have adequate Tier 1 capital to support their liabilities. Tier 1 capital includes common equity, preferred equity and retained earnings. (Note that as per the recently passed Dodd-Frank Act, cumulative preferred and trust preferred securities will eventually be phased out of their Tier 1 capital status.[1]) Since issuing preferred shares is normally cheaper than issuing common shares and avoids common ownership dilution, banks issue preferred shares to meet the required capital ratio set by regulators.
- Preferred shares can be used in balance sheet management. Investors often prefer low debt-to-equity ratios, and issuing preferreds can better help to lower the debt-to-equity ratio than issuing debt. A company in need of additional financing may also be required to issue preferred shares instead of debt to avoid a technical default, which could trigger an immediate call on previously issued bonds or an increase in interest rates on those bonds. A technical default may occur when the debt-to-equity ratio breaches a limit set in a currently issued bond covenant.
- Preferreds give companies flexibility in making dividend payments. If a company is running into cash issues, it can suspend preferred dividend payments without risk of default. Depending on whether the preferred share class is cumulative or non-cumulative, a company may have to pay previously skipped dividend payments before restarting dividend payments in the future.
[1]Source: United States. Office of the Comptroller of the Currency, Treasury; and the Board of Governors of the Federal Reserve System. 2013. “Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule”.
Contributors:
Phillip Brzenk, CFA
Associate Director, Index Research & Design
Aye Soe, CFA
Director, Index Research & Design
About Aye Soe
Aye M. Soe is director, index research and design, at S&P Dow Jones Indices. Aye is responsible for conceptualization, research and design covering global strategy, factor based, alternative beta and thematic indices across different asset classes. Aye also regularly publishes on a number of headline S&P publications as well as research papers related to capital markets and investment concepts.