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8.3.8 Floating-rate Preferred Shares

A comprehensive guide to understanding floating-rate preferred shares, including their market conditions, examples, characteristics, and implications for buyers.

Overview of Floating-Rate Preferred Shares

Floating-rate preferred shares, also known as variable-rate preferred shares, are similar to variable or floating-rate debentures. These securities distribute dividends that adjust according to fluctuations in interest rates. When interest rates increase, dividend payments also rise, and conversely, they fall when interest rates decrease.

Issuance Circumstances

Floating-rate preferred shares are typically issued under two main market conditions:

  1. Challenging Market Conditions: When it’s difficult to sell straight preferreds and the issuer is not inclined to offer convertibility or retraction options. Convertible issues can dilute shareholder equity, while retractable issues let holders force redemption, possibly at unfavorable times for the issuer.

  2. Interest Rate Outlook: When the issuer anticipates stable or slightly increasing interest rates from the new issue date. The issuer is willing to offer higher dividends if rates rise and expects to benefit from smaller dividend payments if rates decline, usually with a guaranteed minimum rate.

Example

MNO Corp.’s Floating Rate Cumulative Series II shares feature cumulative preferential cash dividends. The quarterly dividend rate is one quarter of 70% of the prime rate, applied to $25. The rate is set on the last business day of the preceding month.

Delayed Floating-Rate Features

Some preferred shares include delayed floating-rate mechanisms, also known as delayed floaters, fixed-resets, or fixed floaters. These shares provide a fixed dividend for a certain period before transitioning to a variable dividend rate.

Characteristics of Variable-Rate Preferred Shares for Purchasers

From an investor’s perspective, variable-rate preferreds offer specific traits:

  1. Income Variability: Higher income if interest rates climb, but lower income if rates fall.
  2. Income Uncertainty: Annual income dynamics are hard to predict accurately, adjusting to current interest rate levels.
  3. Market Price Stability: The market value of these shares is less impacted by interest rate changes compared to straight preferred shares because dividend adjustments correlate with interest rates on a predetermined basis.

Key Takeaways

  • Floating-rate preferred shares adjust dividend payments based on interest rate changes.
  • Issued in challenging selling conditions or when issuers expect relatively stable interest rates.
  • May include delayed floating-rate features for initial fixed periods.
  • Offer varying income with each rate change, often less sensitive to market price fluctuation than straight preferred shares.

Glossary

  • Floating-Rate Preferred Shares: Preferred shares that pay dividends which fluctuate in relation to interest rate changes.
  • Convertible: The ability of a security to be converted into another form, such as common shares, potentially dilating existing equity holdings.
  • Retractable: Security feature allowing holders to force the issuer to redeem the security before its maturity, typically under specified conditions.
  • Cumulative Dividends: Unpaid dividends accumulate and must be paid out before any dividends can be paid to common shareholders.
  • Prime Rate: A prime lending rate decided by banks that serves as a benchmark for many financial products.

Frequently Asked Questions

  1. What are floating-rate preferred shares? Floating-rate preferred shares are a type of preferred stock where dividends fluctuate according to changes in interest rates.

  2. Why might a company issue floating-rate preferred shares? A company might issue floating-rate preferred shares during challenging market conditions for straight preferreds or when it believes that interest rates will remain relatively stable or increase just slightly.

  3. How is the dividend rate determined for these shares? The dividend rate for floating-rate preferred shares is typically set as a percentage of a benchmark rate (like the prime rate), recalculated at regular intervals such as quarterly.

  4. What are ‘delayed floaters’? ,These are floating-rate preferred shares that start with a fixed dividend for a predetermined period before transitioning to a variable dividend rate.

  5. How do floating-rate preferred shares affect an investor’s portfolio? These shares can provide protection against rising interest rates with their adjustable dividend structure, making them a hedge against interest rate risk.


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## What is the primary feature of floating-rate preferred shares? - [ ] They pay a fixed amount of dividend irrespective of interest rate changes. - [x] They pay dividends that fluctuate based on changes in interest rates. - [ ] They can be converted into common shares at any time. - [ ] They require mandatory redemption after a specific period. > **Explanation:** Floating-rate preferred shares pay dividends that vary according to changes in interest rates, unlike fixed-rate dividends. ## Why might an issuer prefer to issue floating-rate preferred shares instead of straight preferred shares? - [ ] To make the shares mandatory convertible into debt - [ ] Because floating-rate preferreds offer a fixed dividend rate - [ ] To provide dividends that don’t reflect interest rate changes - [x] When straight preferred shares are hard to sell and the issuer wants to avoid making the issue convertible or retractable > **Explanation:** Issuers may choose floating-rate preferred shares when straight preferred shares are difficult to sell, without making them convertible (avoiding dilution) or retractable (avoiding forced redemption). ## What happens to the dividend payments on floating-rate preferred shares when interest rates rise? - [ ] They remain the same - [ ] They decrease - [x] They increase - [ ] They become fixed > **Explanation:** Floating-rate preferred shares are designed to pay higher dividends if interest rates rise. ## What are MNO Corp. Floating Rate Cumulative Series II shares entitled to? - [ ] Fixed annual dividends irrespective of interest rate levels - [x] Cumulative preferential cash dividends that adjust quarterly based on the prime rate - [ ] Convertible dividends that can be converted into shares - [ ] Non-cumulative dividends fixed for the life of the shares > **Explanation:** MNO Corp. Floating Rate Cumulative Series II shares are entitled to cumulative preferential cash dividends, reflecting changes in the prime rate daily. ## When are floating-rate preferred shares usually issued, according to the text? - [ ] During periods when they are easier to sell than common shares - [x] When a straight preferred is hard to sell and the issuer does not want convertible/retractable options - [ ] Only when interest rates are expected to decline sharply - [ ] When the issuer wants to issue bonds instead of shares > **Explanation:** These shares are issued when straight preferred shares are difficult to sell, and the issuer avoids options that could potentially dilute equity or force redemption. ## What is a key characteristic of variable-rate preferreds from the investor's standpoint? - [ ] They provide fixed income regardless of interest rate changes - [x] They provide income that increases with rising interest rates but decreases with falling rates - [ ] They have a fixed dividend rate for their entire tenure - [ ] Their market price is more sensitive to changes in interest rates compared to straight preferred shares > **Explanation:** Variable-rate preferreds offer income proportional to interest rate changes, reflecting the current economic environment. ## What are some alternative names for preferred shares with delayed floating-rate features? - [ ] Instant floaters - [x] Delayed floaters, fixed-reset, or fixed floaters - [ ] Convertible floaters - [ ] Standard preferred dividends > **Explanation:** These shares, known as delayed floaters, fixed-reset, or fixed floaters, have a predetermined fixed dividend period after which the dividend becomes variable based on rates. ## How do variable-rate preferred shares compare to straight preferred shares in terms of market price sensitivity? - [x] Their market price is less sensitive to changes in interest rates - [ ] Their market price is more sensitive to changes in market conditions - [ ] Their price remains the same regardless of the market - [ ] Their price drops significantly with any change in interest rates > **Explanation:** The dividend payout of variable-rate preferreds adjusts according to interest rates, making their market price less sensitive to interest rate changes than straight preferred shares. ## If an investor holds a variable-rate preferred share, how predictable is their annual income? - [ ] Very predictable and fixed - [ ] Negligible risk in variability - [ ] Not at all affected by interest changes - [x] Variable and difficult to predict accurately > **Explanation:** The annual income from variable-rate preferreds reflects prevailing interest rate levels and is, therefore, difficult to predict with precision. ## Under what circumstances might an issuer choose to issue floating-rate preferred shares, in terms of their assessment of future interest rates? - [ ] When they believe interest rates will rise indefinitely - [ ] When they want to minimize their dividend payout - [ ] When rates are anticipated to fall lower than present levels - [x] When they believe rates will not rise much higher than the initial issue date's rate > **Explanation:** Issuers may prefer floating-rate shares if they expect interest rates to remain relatively stable or not increase significantly, balancing higher dividends against falling rate advantages.

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