What is Callable Preferred Stock?

Callable preferred stock is a type of preferred stock that the issuer has the right to call in or redeem at a pre-set price after a defined date. Callable preferred stock terms, such as the call price, the date after which it can be called, and the call premium (if any), are all defined in the prospectus and cannot be changed later.

Callable preferred stock gives the corporation the right to purchase/retire or “call” the stock from its shareholders at a specific future time and price usually determined at issuance. In other words, the company can force the shareholder to sell his stock back to the company at a given date in the future.

How Does a Callable Preferred Stock Work?

For example, consider Company XYZ preferred stock issued in 2000, paying a 10% rate, maturing in 2020, and callable in 2010 at 102% of par. Ten years from issue, XYZ gains the right to call the stock, which it would likely do if the interest rates in 2010 are lower than 10%.

Usually, the issuer must pay the investor a little over the par value of the stock in order to call the issue. This difference is called the call premium, and the amount typically decreases as the preferreds near maturity. For example, XYZ Bank is offering 102% of face value if it calls the issue in 2010, but it may only offer 101% if called in 2015.

Features:

Callable Preferred Stocks are highly popular because of the much-needed flexibility it provides to the issuing company. Callable Preferred Stocks have the following salient features:

• Callable Preferred Shares have no voting rights. Just like normal preferred shares, they are entitled to yearly (or quarterly) dividend payments. Therefore, they have no say in managing how the company runs and functions.
• Callable Preferred Shares are redeemable. This means that they can be called back, or repurchased by the issuer. This rate is predetermined when those shares are issued.
• Callable Preferred Shares can only be sold back to the company, when the company wants to repurchase those shares back. This cannot be done unless the company does not personally want to calls back shares.
• Issuing callable preferred stocks comes with a price for the issuer in the form of call premium. This is because investors need to be compensated for the call back risk.
• Regardless of the fact that the owner of the stock is meant to bear the loss associated with call back, if any, the strike price is decided to ensure that they are compensated for this loss.

Why Does a Callable Preferred Stock Matter?

Owners of callable preferred stock bear call risk, and the strike-price premium is meant to compensate the holder for some or all of this risk. For preferred stock in particular, which almost always pays a dividend, the prospect of having the stock called away can be especially daunting for income investors who depend on the stream of cash the stock supplies.

It is important to note that the price of callable preferred stock is affected by whether the call option is in the money, at the money or out of the money. For example, if the stock is callable at $100 and the shares are trading very close to that (say, at $99), the likelihood that the stock will be called soon is much higher than if the stock were trading at $89 (further away from the strike price). As a result, because investors know that the issuer will probably call the shares if they trade above $100, the stock’s price appreciation is effectively capped at $100 per share.

What are the advantages of a Callable Preferred Stock?

Advantages to the Issuer

An issuer of a Callable Preferred Stock has multiple advantages. The Company can recall shares after a certain period of time, and thus the management can always stay in control of the ownership of the company. It will not have the fear of losing the ownership rights to the company permanently. These shares do not come with the right to vote. Hence, such shareholders cannot control a company by exercising their voting rights.

These shares can also help to bring down the cost of capital of the company in some cases. Many times, companies issue these shares to meet their fund requirements. They do not opt for raising funds by means of bank loans, or by the issue of debentures. These methods of raising funds are mostly more expensive and come at a higher rate of interest. Thus, they end up saving a lot of money on interest.

Also, a company has the right to recall such preference shares but there is no such compulsion for the same. In case the interest rates go up in the economy, the company can continue to pay dividends on such shares at a rate lower than the prevailing interest rate. It shall not exercise its right to recall. Hence, its cost of capital will go down.

Advantages to an Investor

An investor usually gets a steady and higher return from Callable Preferred Shares than other equity shares. They get a preference in case of payment of dividends and repayment. The issuing company pays a call premium to an investor at the time of the call. This is a form of compensation for the investors for the reinvestment risk they may face. This is so because the investor will have to reinvest the money from the recall in other investment avenues with a lower interest rate or with lower dividends.

Investors face little or no risk in the case of a fall in the equity stock markets. They have an assurance of the buyback price of their shares as the buyback price is already fixed at the time of the issue.

What are the Disadvantages of a Callable Preferred Stock?

Disadvantages to the Company or Issuer

The issuer or the company has to keep a stockpile of cash ready with them in case it decides to call such preference shares. Also, they have to pay a premium price on recall which can be an additional burden on the resources of the company.

Also, the issue of such shares may make the shareholding pattern quite complex and may increase the costs of compliance.

Disadvantages to the Investors

Such shareholders can be at a disadvantage especially when the prevailing stock price is much higher than the call price. The company will exercise its right to call back the share and the holders of the shares will have to abide by it. More often, there is an automatic capping on the price of the shares. As soon as the market price of the shares goes up considerably above the call price, the company will immediately call back the shares. Thus, the upside potential for share prices becomes limited.

In the opposite case, if the market price of the share falls considerably below the call price, the issuer may not exercise its option to call only. The issuers have the benefit of having a choice to exercise the right to recall. This proves to be a disadvantage for the shareholders.

Callable vs. Retractable Preferred Shares

While callable shares may be redeemed by the issuer, retractable preferred shares are a type of preferred stock that lets the owner sell the share back to the issuer at a set price.

Sometimes instead of cash, retractable preferred shares can be exchanged for common shares of the issuer. This may be referred to as a “soft” retraction, compared with a “hard” retraction where cash is paid out to the shareholders.