How Does Perpetual Preferred Stock Work?

Perpetual preferred stock is a hybrid security, blending features of both equity and debt. It represents an ownership stake in a company, similar to common stock, but it also shares characteristics with bonds. A defining feature is its lack of a maturity date; the stock is not required to be redeemed by the issuer at any point, allowing it to exist indefinitely. Investors who purchase these shares are entitled to receive fixed dividend payments for as long as the company is in operation.

These securities are designed to attract investors who seek a balance between the relative safety of debt instruments and the ownership component of equity. Companies issue this type of stock to raise capital without taking on formal debt or diluting the voting power of common shareholders.

Core Features and Shareholder Rights

For the issuing company, this type of stock provides a stable, long-term source of capital that does not carry the repayment obligations of a bond. The shares trade on public exchanges, much like common stock, allowing investors to sell their holdings to other investors if they wish to exit their position.

Dividend payments are a central feature, and they are most often paid at a fixed rate. Some perpetual preferred stocks are structured with floating or adjustable rates, where the dividend payment changes periodically based on a benchmark interest rate. Regardless of the structure, preferred shareholders have priority over common shareholders for dividend payments.

A distinction exists between cumulative and non-cumulative shares. If a company misses a dividend payment on cumulative preferred stock, that unpaid dividend accrues and must be paid in full before any dividends can be distributed to common stockholders. For example, if a company with cumulative shares skips a $2 annual dividend for two years, it must pay $4 in back-dividends to preferred holders before common shareholders can receive anything. In contrast, if the shares are non-cumulative, a missed dividend is lost permanently to the investor.

In the event of a company’s liquidation or bankruptcy, perpetual preferred shareholders have a superior claim on the company’s assets compared to common stockholders. They are paid after all debts to bondholders and other creditors have been settled but before any remaining assets are distributed to common shareholders. This liquidation preference places them in a less risky position than common equity investors.

Holding perpetual preferred stock does not grant the shareholder voting rights in the company, a difference from common stock. In some specific circumstances, such as the company failing to pay dividends for an extended period, limited voting rights may be temporarily granted to preferred shareholders as a protective measure.

Issuer-Specific Provisions

Companies often embed a call provision, also known as a redemption feature, into the terms of a perpetual preferred stock offering. This gives the issuer the right, but not the obligation, to buy back the shares from investors at a predetermined price, known as the call price. This right is exercisable after a specific date. A reason for including a call feature is to gain financial flexibility. If interest rates in the market fall significantly below the fixed dividend rate of the preferred stock, the company can redeem the shares and potentially issue new ones at a lower rate, reducing its cost of capital.

Another common feature is a conversion right, which benefits the shareholder. This provision allows an investor to convert their perpetual preferred shares into a specified number of the company’s common shares. The exact number is determined by the “conversion ratio,” which is set when the stock is first issued. This feature is attractive because it offers the stable income of a preferred stock along with the potential for capital appreciation if the company’s common stock price increases significantly.

Valuation Methods

The most common method for valuing a perpetual preferred stock is a version of the dividend discount model designed for a perpetuity. The formula is straightforward: the price of the stock is equal to its annual dividend payment divided by the investor’s required rate of return.

The annual dividend is the fixed cash payment the investor expects to receive each year, a feature established in the stock’s offering documents. The required rate of return is the minimum return an investor is willing to accept for taking on the risk of owning the stock. This rate is influenced by the current risk-free interest rate, such as that on a U.S. Treasury bond, plus a risk premium that accounts for the specific creditworthiness of the issuing company and general market conditions.

For instance, if a perpetual preferred stock pays an annual dividend of $6 per share and an investor determines their required rate of return is 7%, the valuation would be calculated as $6 divided by 0.07. This results in a price of approximately $85.71 per share. If the market price is below this value, the investor might consider it a good buying opportunity.

Tax Implications

For individual investors in the United States, the dividends received from perpetual preferred stock are often considered “qualified dividends.” This treatment is beneficial because qualified dividends are taxed at the lower long-term capital gains tax rates, which can be 0%, 15%, or 20% depending on the investor’s taxable income. This is more favorable than the tax treatment for interest income from corporate bonds, which is taxed at higher ordinary income tax rates.

For the issuing corporation, the tax treatment is different from debt financing. When a company pays interest on bonds, that interest expense is tax-deductible, which lowers the company’s taxable income. However, dividends paid on perpetual preferred stock are not tax-deductible. These payments are considered a distribution of profits to owners and are made from the corporation’s after-tax earnings.