Indexology: 3 Reasons Companies Issue Preferreds

November 8th at 7:30am by Indexology Blog

Companies may issue preferred stocks for a variety of reasons.  The three reasons below are the most common.

  1. 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.
  2. 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.
  3. 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.

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