Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Callable Preferred Stock

What it is:

Issuers of callable preferred stock have the right (but not the obligation) to repurchase the stock at a specific price after a certain date.

How it works (Example):

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.

Why it Matters:

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.

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