Redeemable preferred stock, also known as callable preferred stock, is a type of preferred stock that has a callable provision that allows the issuing company to buy back the stock at a fixed price after a specified period of time. The possibility of returning investors' investment principal makes redeemable preferred stock more like a debt security. Offering higher preferred dividend than other preferred stocks and debt in general, redeemable preferred stock can be attractive to certain fixed-income investors.
Redeemable preferred stock can be a more suitable funding alternative to debt and equity financing in certain situations. For companies with financial conditions less than strong, traditional debt funding can be a burden on them with insufficient cash flows because of the promise of returning borrowed principal and the continual interest payment. Meanwhile, issuing common equity would immediately dilute existing common shareholders' financial interest. Preferred stock with a redeemable feature can be acceptable to both fixed-income and equity investors.
When using redeemable preferred stock, the issuing company has the option to buy back the stock in the future. If the company is not yet in a financial position to redeem the stock, it may not need to pay back investors. But if the company has improved its financial condition, it may retire the redeemable preferred stock and switch to debt financing, as preferred stock of any kind is a more expensive means of financing.
All else being equal, redeemable preferred stock is more likely to be issued during times when interest rates are high. Preferred dividend as a form of fixed income must be set to be comparable to the prevailing market interest rates at the time of issuance. As interest rates change over time, with redeemable preferred stock, the issuing company would have a chance to call back the stock if interest rates have declined at the time of the scheduled redemption and be able to issue new shares at a low rate.
Despite bearing the label stock, redeemable preferred stock cannot be classified in a company's capital structure as equity on its balance sheet, based on the rules of the U.S. Securities and Exchange Commission. Redeemable preferred stock may be listed in a mezzanine section in between liability and shareholder equity. The fact that redeemable preferred stock has a liability's characteristic of probable future asset settlement requires that separate cash obligation be kept from permanent capital.
Redemption of redeemable preferred stock depends on future developments in the company's performance and market conditions. Such a contingent event adds uncertainties to company management and market observers. At a certain point, the company must make adjustments to its business operations and financial management as to whether to redeem the stock. When conducting debt-to-equity ratio analysis, financial analysts and credit rating agencies that follow the company must make their own judgment regarding the future status of redeemable preferred stock being potentially debt or equity, as the company may or may not call the stock.
An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.