Updated July 15, 2023
Definition of Callable Preferred Stock
Callable preferred stock is 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 a difference between “right” to buy & “obligation” to buy. Right to buy means you may or may not buy the stock & depending on your choice. Obligation means you have to buy the stock since you have the obligation compulsorily. Thus, callable preferred stocks have the right to buy & not the obligation to buy.
- The company issues callable preferred stock. The company has the 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 an “obligation to sell” the stock at the pre-determined price.
- This pre-determined price specifies in the issue’s prospectus and cannot change at the time of redemption of the stock.
- These stocks are also called Callable preferred shares.
How Does It Work?
- At the inception, the 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 investors retain, these stocks expect higher returns during the holding period. Thus, the dividend is higher & the callable price is higher than the face value.
- Now, the call price (i.e., redemption price) should include the premium 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 yearly, but the same accumulates as a “dividend in arrears”. So, investors do not lose on the basic return, i.e., the dividend part. The liability to pay dividends exists in these stocks due to the feature of “Preference” stocks. Preference stock has 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 issue at a lower dividend rate & the specified date in the prospectus has elapsed.
- To pay the huge amount, the company usually finances the same through a debt (from the bank) at a lower interest rate. Pays the same to the shareholders. Issues new stocks with lower dividend rates. The issue amount is paid back to the bank that financed the arrangement. So, in the future, the company’s obligation for dividends will reduce substantially.
Example of Callable Preferred Stock
Let’s take the example of John Inc.
Solution:
Say, the interest in the market is reduced to 7% due to the 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 a 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 the 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 |
| The new issue of shares | $ 15,000 |
| Issue Price (Face value = 100 $) | $ 105 |
| The amount received through the 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 the 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 issuer company can control the financing cost of the preferred stock.
- As explained earlier, the company can issue new shares at a comparatively lower dividend rate since the interest rate in the market has fallen.
- These stocks help the issuer company adapt to the country’s changing market scenarios. The changing interest rates reflect 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.
- Investors carry a higher risk over & thus. A higher dividend rate compensates for the same.
Reasons for Using Callable Preferred Stock
- Higher the risk, the higher the return. The pricing attracts investors to preferred stock.
- Callable preferred stock is a means of refinancing the stock issue.
- The company can also maintain voting rights in control since callable preferred stock does 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 favor of the issuer-company | It works in favor of the investors. |
| The dividend rate is generally higher. | The dividend rate is generally lower. |
| The issuer company has to pay the cash in case of the option is exercised. | These stocks can exchange for common stocks at the investor’s choice. |
| Gives financial flexibility to the issuer. | Gives financial flexibility to the investor. |
Advantages
Below are some of the advantages :
- Till the issuer company repurchases the shares, the company need not worry about losing a majority stake in the company by the investors.
- Issuer-company is in a favorable position since it retains the right to buy at the right time.
- Regarding voting rights, the company need not worry about the same since preferred shares do not have voting rights to the said investors. Thus, normal decisions can be made without interference from 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
Below are some of the disadvantages :
- The disadvantage relates to the investor who must sell the stock if the company decides to return them.
- The investors lose the interest component for dividends in arrears for the years.
- If the stock is on the upswing, the investors prefer to retain the stock. After the specified, they must sell the same in the stock’s upside. Thereby losing on the potential gain.
- Generally, after the call decision is announced in the market, the share prices start consolidating toward the face value of the stock.
- The market captures the call decision negatively.
- Providing a higher rate of return to preferred shareholders may give insecurity to the common shareholders.
Conclusion
The company exercises the call option only when it has the potential to explore the market scenario through funding. Calling 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. The company only has to issue notice to the preferred stockholders. Paying the cash is not a tough job if the company has a sufficient surplus for disposal. Even if the company does not have surplus funds, it can acquire debt at prevailing lower market rates. For the time being, the calling decision impacts the share price negatively.
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