Last year U.S. companies raised $25.5 billion by issuing preferreds -- a special class of stock that pays a fixed dividend. But they sopped up 22 times that amount -- a whopping $548.9 billion -- by selling bonds, according to Thomson Financial and Dealogic. Common shares accounted for $104.2 billion; convertible securities, $59.9 billion.
These lopsided totals reflect market forces. During the 1990s bull market, investors favored capital gains over dividend payouts. Income-minded buyers put their money into corporate bonds, which offered heftier yields than preferreds and more senior placement in corporate capital structures. Moreover, companies got a tax deduction for interest payments but not for dividends, while investors paid the same levy on both.
Unsurprisingly, corporations viewed issuing this form of stock with all the enthusiasm of Herman Melville’s Bartleby the scrivener: They preferred not to. As the bull market peaked in 2000, companies sold just $9.56 billion in preferreds -- barely half 1999’s total and the lowest level in more than a decade (see chart).
But some experts foresee a boom for preferreds, as bear-market-weary equity investors seek more stable returns from the conservative, cash-rich concerns such as utilities and banks that traditionally have paid dividends.
“Preferred stocks used to be issued quite regularly, if you go back 25 or 30 years,” says Gary Stark, president of Stark Financial Advisers, a Delray Beach, Florida, firm with some $250 million in assets under management. “But in the ‘80s and ‘90s, companies found it a lot cheaper to pay no dividends. Investors accepted this because of the capital gains they were making. But then the bubble burst, and investor perceptions changed.”
Another boost could come from the $350 billion federal tax cut that President George Bush signed into law on May 28. The measure reduces the tax on dividend income to 15 percent from ordinary income tax rates as high as 35 percent. Companies such as Bank of America and Microsoft Corp. already are responding to these developments by hiking or instituting dividends on their common shares.
Issuers are expected to take the next step in tapping renewed demand for dividends by selling new preferred stock and retiring debt, which would benefit both themselves and investors.
Preferred buyers get fixed dividends that typically can’t be reduced by the company, are higher than common dividends and are paid first if earnings are insufficient to cover both. More broadly, preferred holders can reap equitylike capital gains and enjoy bondlike downside protection, with about half the tax burden.
Companies that replace bonds with preferred stock can reduce leverage while paying lower yields. And they can accomplish these feats without diluting the control of existing owners, as preferreds carry no voting rights. This feature may dissuade some activist institutions, but shouldn’t trouble retail investors.
“Because preferreds trade in $25 increments on the stock exchange, it’s easier for us to invest $5,000 or $10,000 of a client’s money into them and have liquidity, as opposed to the bond market, which can be a snakepit if you’re not buying in very large quantities,” says Susan Breakefield Fulton, a portfolio manager at Bethesda, Maryland, investment adviser Fulton Breakefield Broenniman.
Additionally, “true” preferreds are in short supply today. Recent issuance has been dominated by trust preferreds and convertible preferreds, which are classified as debt for tax purposes and thus not covered by the dividend tax cut. To meet demand for tax- advantaged preferreds, corporations likely will have to step up issuance.
If they do, preferred stock might just regain its capital markets status.
