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Preferred Stock Paper

5155 words - 21 pages

The Risks of Preferred Stock Portfolios
SLCG Working Paper 1
Abstract Preferred stocks are a hybrid of debt and equity. In this paper, we examine preferred stocks with an emphasis on the risks of holding portfolios of preferred stocks. We demonstrate that preferred stocks are similar to debt when the issuing company is financially healthy, and become more similar to equity when the company’s financial condition deteriorates. We show that issuers of preferred stocks are heavily concentrated in the financial services industry, a fact that exposes investors who hold a portfolio concentrated in preferred stocks to further risk - industry concentration risk. We illustrate the features of ...view middle of the document...

com and Dr. O’Neal can be reached at 336-665-8718 or This paper benefitted greatly from the collaborative effort of employees of SLCG.


2 stocks have become more prevalent. Dividends on non-cumulative preferred stocks can be omitted for years and only the current preferred stock dividend has to be paid before dividends can be paid to common stock holders. Although preferred stocks have attributes of both debt and equity, they are technically considered an equity security (hence the term preferred stock) since the dividends are not contractual obligations of the company (as debt interest payments are), but rather are at the discretion of the company’s board of directors.
Figure 1: Number of Issues of Preferred Stocks in 1994-2009.
This figure presents the number of new public issuances of preferred stocks between 1994 and 2009 for the financial and the non-financial sectors. 600 500

Financial Sector
400 300 200 100 0

Non-Financial Sector

Prior to the 1980s, most preferred stocks were issued by regulated utility companies. From 1950 to 1979, 90 of the 108 preferred stock offerings were made by utilities. In the mid-1980s, financial firms began to issue preferred stocks, but the explosive growth in preferred stock issued by financial firms did not occur until after the Federal Reserve’s 1996 ruling on Tier 1 capital. Financial institutions became the dominant issuers of preferred stocks by the late 1990s. While non-financial firms in aggregate have been issuing a steady 30 to 60 new preferred stocks a year over the past two decades, financial firms have dramatically increased the number of preferred stock offerings from nine in 1994 to over 500 in 2009. See Figure 1.

The Risks of Preferred Stock Portfolios

3 Financial institutions issued $833 million or 44% of the $1.9 billion in preferred stock issued in 1994. By 2008, at the peak of preferred stock issuances, financial institutions issued $193 billion or 95% of the $201 billion in new preferred stock public offerings. See Figure 2. The dramatic increase in preferred stock

offerings by financial services firms was spurred by regulatory treatment of qualifying preferred stock as capital and the development of Trust Preferred Securities which allowed firms to fund preferred dividend payments with interest payments which the IRS treats as tax deductible interest expense.
Figure 2: Total Offering Value of Preferred Stocks Issued, 1994-2009.
This figure presents the amount in billions of dollars of new public issuances of preferred stocks between 1994 and 2009 for the financial and the non-financial sectors. $200 $180 $160 $140 Billion $120 $100 $80 $60 $40 $20 $0

Financial Sector Non-Financial Sector

The Federal Reserve requires banks to maintain a certain level of permanent capital, or “Tier 1” capital, to control banks’ risk profiles and thus protect investors and the banks’ depositors. This permanent capital is essentially equity capital...

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