3 Reasons Companies Issue Preferreds

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

For more on preferreds, read our recent paper, “Digging Deeper Into the U.S. Preferred Market.”

The posts on this blog are opinions, not advice. Please read our disclaimers.

2 thoughts on “3 Reasons Companies Issue Preferreds

  1. chris wigand

    good article on preferreds. I was wondering if your familiar with the calls that are attached to the preferreds ? Yesterday wells fargo called there WNA preferred on a special event call in the prospectus . How many of the existing preferreds have these calls . This particular one was a non call until 2022 then 25 par. Looking at the prospectus there is an occurence of a Special Event which may be ” a tax event , An Investment company act event , or a regulatory Capital Event . I’m not a CFA or a Lawyer but which one was this ? I deal with retail and they are furious over this. Maybe an article on that Clause in the prospectus would be beneficial to all. The term caveat emptor seems to shine here.

    Reply
    1. Aye Soe

      We don’t keep track of which preferreds have a special events clause in their prospectus. In this case, Wells Fargo stated that the redemption was due to a Regulatory Capital Event (as seen in Form 8-K published on the SEC website) triggered by changes in regulatory capital rules in Basel III. As we mentioned in our paper, certain types of preferred securities will no longer be considered Tier 1 Capital under Basel III so it is possible other financial institutions will follow suit.

      Reply

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