Adjustable-Rate Preferred Stock

Definition

Adjustable-rate preferred stock is a type of preferred stock where the dividend rate is periodically reset, typically based on a reference interest rate or index. This allows the dividend yield to fluctuate over time in response to changes in market conditions, providing issuers with more flexibility in managing their capital structure and investors with exposure to variable income streams.

5 Must Know Facts For Your Next Test

1. Adjustable-rate preferred stock provides issuers with more flexibility in managing their capital structure compared to fixed-rate preferred stock.
2. The dividend rate on adjustable-rate preferred stock is typically reset at predetermined intervals, such as quarterly or annually, based on a reference interest rate or index.
3. Adjustable-rate preferred stock allows investors to participate in changes in market interest rates, as the dividend yield will fluctuate with the reference rate.
4. Issuers may use adjustable-rate preferred stock to match the duration of their assets and liabilities, reducing interest rate risk.
5. Adjustable-rate preferred stock can be more attractive to investors during periods of rising interest rates, as the dividend yield will increase to reflect the higher market rates.

Review Questions

• Explain how the adjustable-rate feature of preferred stock differs from fixed-rate preferred stock.
  • The key difference between adjustable-rate preferred stock and fixed-rate preferred stock is the way the dividend rate is determined. With fixed-rate preferred stock, the dividend rate is set at a constant percentage of the par value and does not change over the life of the security. In contrast, the dividend rate on adjustable-rate preferred stock is periodically reset, typically based on a reference interest rate or index, allowing the yield to fluctuate in response to changes in market conditions. This provides issuers with more flexibility in managing their capital structure and allows investors to participate in changes in market interest rates.
• Describe the potential benefits of using adjustable-rate preferred stock for both issuers and investors.
  • For issuers, the use of adjustable-rate preferred stock can provide more flexibility in managing their capital structure by allowing the dividend rate to be adjusted in response to changes in market conditions. This can help issuers better match the duration of their assets and liabilities, reducing interest rate risk. For investors, adjustable-rate preferred stock can be more attractive during periods of rising interest rates, as the dividend yield will increase to reflect the higher market rates. This provides investors with exposure to variable income streams that can potentially generate higher returns as interest rates rise.
• Analyze how the adjustable-rate feature of preferred stock impacts the risk and return profile compared to fixed-rate preferred stock.
  • The adjustable-rate feature of preferred stock introduces additional risk and return considerations compared to fixed-rate preferred stock. On the risk side, the fluctuating dividend rate exposes investors to interest rate risk, as the yield on the preferred stock will vary with changes in the reference rate. This can make the income stream less predictable than fixed-rate preferred stock. However, the adjustable-rate feature also provides the potential for higher returns during periods of rising interest rates, as the dividend yield will increase to reflect the higher market rates. This can make adjustable-rate preferred stock more attractive to investors seeking variable income streams and the opportunity to participate in changes in market conditions. The tradeoff between the increased risk and potential for higher returns is a key consideration when evaluating adjustable-rate preferred stock versus fixed-rate preferred stock.

Related terms

Preferred Stock: Preferred stock is a type of equity security that provides the holder with priority in dividend payments and liquidation rights compared to common stock, but typically does not carry voting rights.

Dividend Rate: The dividend rate is the percentage of the par value of a preferred stock that is paid out as dividends to shareholders.

Reference Rate: A reference rate is an interest rate or index that is used as a benchmark to determine the adjustable dividend rate of preferred stock, such as LIBOR or the U.S. Treasury yield curve.