What is Adjustable-Rate Preferred Stock?

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  • 20 Dec 2023
What is Adjustable-Rate Preferred Stock?

Key Highlights

  • Adjustable-rate preferred stocks (ARPS) are preferred stocks with variable dividend rates depending on an underlying benchmark.

  • They have a fixed dividend reset date. The rate keeps changing on the basis of the benchmark's performance.

  • The collared dividend movement sets floors and caps on dividend yields. Floors ensure a minimum dividend if interest rates drop. Conversely, caps the limit returns if rates rise.

  • ARPS can offer higher returns if benchmark rates rise and help in portfolio diversification. Moreover, it provides stability and priority in dividend payments over regular stocks.

Adjustable-Rate Preferred Stock (ARPS) is a type of preferred stock that has a predetermined dividend reset date. The dividend is based on changes in the benchmark rate. The Treasury bills issued by governments are the most common benchmark rate. The issuer sets the benchmark rate and calculation method while issuing ARPS. These stocks have a rate cap and floor on their dividends. This ensures that the issuer won't have to pay a huge amount in dividends.

Adjustable-rate preferred stocks come with a specified dividend reset date. This date marks the adjustment of the dividend rate as per the underlying benchmark's performance. The ARPS dividend rate rises with an increase in the benchmark rate. On the other hand, the dividend rate of the ARPS can also drop if the benchmark rate falls.

The dependence of dividends on benchmark rates enables investors to benefit from an increase in interest rates. At the same time, they provide stability and priority over common stocks. Investors must monitor the benchmark rates closely since they are a major factor in determining the returns on ARPS.

Now that you understand the meaning of the adjustable-rate preferred stock meaning, let’s find out its features. The key ones include the following:

  • Preference over equity: Companies first pay dividends to adjusted-rate preferred shareholders before paying dividends to equity holders.

  • Consistent market worth: The market value of an adjustable-rate preferred stock is more consistent compared to a fixed-rate preferred stock. Fixed-rate preferred stock values increase when interest rates decline. Their value decreases when rates rise. Adjustable-rate preferred stocks have an in-built rate adjustment mechanism. So, their market value stays relatively constant. This protects the stock value from fluctuations in interest rates.

Collars are the fixed standards set for an adjustable-rate preferred stock. These are essentially floors and caps based on dividend yields.

A floor is the minimum dividend on ARPS that investors would receive if interest rates dropped. Conversely, a cap determines the highest return that investors will get as dividends. Investors usually don't like caps. If interest rates decline on the other side of a collar limit, ARPS works just like fixed-rate preferred stocks.

Many adjustable preferred stock issuers adjust their dividend yields through regular auctions. The present goals of investors are the basis for the ARPS dividend yields.

The following are the key adjustable-rate preferred stocks.

1. Possibility of Higher Returns: ARPS may give dividends at a higher rate if the benchmark rate rises. This would make them a good investment option for those looking for higher returns.

2. Stability and Priority: ARPS generally have a greater priority to get dividends than regular stocks. So, investors benefit from higher returns and stability compared to common shareholders.

3. Diversification: ARPS provides a different risk-return profile than other conventional investment instruments like equities or bonds. So, investing in them helps in portfolio diversification.

Conclusion

Adjustable-rate preferred stock is a unique type of preferred stock that gives dividends based on a particular benchmark rate. Investors get the advantage of varying benchmark interest rates. They get higher dividends when the rates increase. ARPS has the potential to provide higher returns and stability. It can also aid in portfolio diversification. Still, it is crucial to do extensive research. Take into account your financial objectives and risk tolerance. Make sure they are aligned with your investment goals.

FAQs on Adjustable-Rate Preferred Stock

The interest rate and the value of a fixed-rate preferred stock have an inverse relationship. The stock price drops when interest rates rise. This is because investors now think the preferred shares are less profitable. On the other hand, the preferred stock price will rise if interest rates decrease.

Adjustable-rate preferred stock has built-in rate adjustments. So its market value is more stable. It doesn’t depend too much on the fluctuations in interest rates in an economy.

Investing in adjustable-rate preferred stocks has one significant disadvantage. Its dividend payout decreases with changes in the benchmark interest rate.

Companies usually issue adjustable-rate preferred stocks to manage their financing costs. Sometimes, benchmark interest rates may fluctuate. So, issuing ARPS allows companies to pay dividends as per the prevailing interest rates.

The frequency of dividend rate adjustments usually varies. It may be done monthly, quarterly, semi-annually, or annually. It depends on the terms and conditions of the security mentioned during issuing it.

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