Callable Preferred Stock

Definition of Callable Preferred Stock

Callable preferred stock is basically a preferred stock wherein the issuer company retains/has the right (and not “obligation”) to call-back (i.e. repurchase) the stock at a specific price (usually at a premium to face value) after a specific date which is specified in the term of the prospectus used for the issue of such stock.

Explanation

• The word “callable” means “a right to buy”. There is difference between “right” to buy & “obligation” to buy. Right to buy means you may or may not buy the stock & depends on your choice. Obligation means you have to compulsorily buy the stock since, you have the obligation. Thus, callable preferred stocks have right to buy & not the obligation to buy.
• Callable preferred stock is issued by the company. The company has right to buy the stock from the shareholders at the pre-determined price after a specific date has elapsed. On the other hand, in the same situation, the shareholder has “obligation to sell” the stock at the pre-determined price.
• This pre-determined price is specified in the prospectus of the issue and cannot be changed at the time of redemption of the stock.
• These stocks are also called as Callable preferred shares.

How Does It Work?

• At the inception, company issues the prospectus detailing the terms & conditions of preferred stock-issue with the feature that the stock is “callable”.
• Callable means right to buy (for the issuer-company) and obligation to sell (for the investor). Due to the risk retained by investors, these stocks are expected to give higher returns during the holding period. Thus, dividend is higher & the callable price is higher than the face value.
• Now, the call price (i.e. redemption price) should include the premium over above the face value of the stock & the pending dividends over the years.
• Thus, the dividends on such stock may or may not be paid every year but the same gets accumulated as “dividend in arrears”. So, investors do not lose on the basic return i.e. the dividend part. The liability to pay dividend is existing in these stocks due to the feature of “Preference” stocks. Preference stock have the right to receive the cumulative dividend.
• Issuer-company uses this right to buy when the interest rate in the market has fallen, the new stocks can be issued at lower dividend rate & the specified date in the prospectus has elapsed.
• Now, for paying the huge bucks of the amount, company usually finances the same through a debt (from bank) at lower rate of interest. Pays the same to the shareholders. Issues new stocks with lower dividend rate. The issue amount is paid back to the bank who financed the whole arrangement. So, in the future, company’s obligation for dividend is reduced substantially.

Example of Callable Preferred Stock

Let’s take an example of John Inc.

Solution:

Say, the interest in the market is reduced to 7% due to global crisis from January 2020. The company decides to call back the shares @ 103% price & dividend in arrears to be paid. The arrangement would take 2 months to complete & within 2 months, new stocks will be issued at 6% dividend rate.

Redemption Value (10000 * $ 100 * 103%)	$ 10,30,000
Dividend to be paid (10000*$100*11%*4 years)	4,40,000
Total Amount to be paid back	$ 14,70,000
Re-financed the same from bank	$ 14,70,000
Rate of interest to be paid at	7%
Periodicity to paid for	2 months
Interest Outflow for 2 months (1470000 * 7% *2/12)	$       17,150
New issue of shares	$       15,000
Issue Price (Face value = 100 $)	$            105
Amount received through issue (15000 * 105)	$ 15,75,000
Dividend Rate	6%

Explanation

• You can see that the amount of debt from the bank ($ 1470000 + Interest) is paid through issue of new stocks at a new price with a lower dividend rate.
• The company could exercise the call option due to the fall in interest rate after the specified date (01/01/2020).
• In this, it is a combination of equity & debt financing.

Importance of Callable Preferred Stock

• The financing cost of the preferred stock can be controlled by the issuer-company.
• As explained earlier, company can issue the new shares at comparatively lower dividend rate since the interest rate in the market has fallen.
• These stocks help the issuer-company to adapt to the changing market scenarios around the country. The changing interest rates reflects the market situation.
• Since it is a “right” to buy & not an “obligation” to buy, the company may not exercise the right if the interest rate in the market has risen.
• Investor carry a higher risk over & thus, the same is compensated by higher dividend rate.

Reasons for Using Callable Preferred Stock

• Higher the risk, higher the return. The investors get attracted to the pricing of the preferred stock.
• Callable preferred stock is a means of refinancing the stock issue.
• Company can also maintain the voting rights in control since, callable preferred stock do not have voting rights.
• However, the call price of such stock depends on the fact whether the call option of the same stock in the market is trading “in the money”, “at the money” or “out of the money”.
• Say the stock price is trading at $ 550. The stock is callable at $ 520. The call price of the stock is in the money. The company can call the stock at $ 520.

Callable Preferred Stock vs Retractable Preferred Stock

Callable Preferred Stock	Retractable Preferred Stock
It gives the issuer-company, the right “to buy” the stock.	It gives the investors, the right “to sell” the stock
It works in favour of the issuer-company	It works in favour of the investors.
Dividend rate is generally higher.	Dividend rate is generally lower.
Issuer company has to pay the cash in case of the option is exercised.	At the choice of investor, these stocks can be exchanged for common stocks.
Gives financial flexibility to the issuer.	Gives financial flexibility to the investor.

Advantages

Some of the advantages are given below:

• Till the shares are repurchased by the issuer company, the company need not worry about losing a majority stake in the company by the investors.
• Issuer-company is at favourable position since it retains the right to buy at the right time.
• As far as voting rights are concerned, company need not worry about the same since preferred shares do not have voting rights to the said investors. Thus, the normal decisions can be made without interference of preference shares holders.
• Preferred shareholders acquire like a debt-holder.
• The funding for the redemption can be arranged through banks & hence, the company need not worry about paying the call price.

Disadvantages

Some of the disadvantages are given below:

• The disadvantage relates to the investor who has to sell the stock if the company decides to redeem them back.
• The investors loose interest component for dividend in arrears for the years.
• If the stock is into upswing, the investors prefer to retain the stock. After the specified, the have to sell the same in the upside of the stock. Thereby losing on the potential gain.
• Generally, after the call decision is announced in the market, the share prices start consolidating towards the face value of the stock.
• Market captures the call decision in a negative manner.
• Providing higher rate of return to preferred shareholders may give insecurity to the common shareholders.

Conclusion

Company exercises the call option only when it has potential to explore the market scenario through funding. Call the preferred stock also changes the capital structure of the company. Calling the preferred stock is much easier since the terms of the call price are already mentioned in the prospectus at the time of issue. Company only has to issue notice to the preferred stock holders. Paying the cash is not a tough job if company has sufficient surplus available for disposal. Even if company does not have the surplus funds, it can acquire debt at prevailing lower market rates. For the time being, calling decision impacts the share price on the negative side.

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