Preferred shares of company stock are often redeemable, which means that there's the likelihood that the shareholders will exchange them for cash at some point in the future. Shares that are convertible, on the other hand, give shareholders the opportunity to exchange them for shares of the company's common stock.
When shares of preferred stock are redeemable, it means the company that issued them has the right -- or the obligation -- to buy those shares back from the shareholders at some point in the future. Redeemable shares are also known as callable shares, because the issuing company can call them in. The stock's prospectus should identify the call price or the price at which the company will buy back the shares, and the call date, which is when the company has the right to call in the shares. The call price is typically equal to or slightly higher than the price at which the company originally sold the shares. The call date is typically five years from the date the company issued the shares.
Maturing vs. Perpetual
Companies aren't required to redeem their shares at the call date. That's just the first date at which they can do so. A redeemable share may have a maturity date, in which case it is "mandatorily redeemable," or it may be perpetual. If it has a maturity date, then the company is obligated buy the share back for the call price on that date. Mandatorily redeemable shares typically have maturities of 30 years or longer from the date they're issued. Perpetual redeemable shares, on the other hand, carry no such obligation for the issuer. Once the call date passes, the company can could call them at any time -- or never call them.
Companies frequently call in their redeemable shares when interest rates fall. Preferred shares pay shareholders a guaranteed dividend that's a percentage of the issue price. To get investors to buy the shares, the dividend percentage has to be competitive with interest rates on other investments. For example, if bonds are paying 6 percent interest, then a company can issue preferred shares with a 6 percent dividend. If bond yields drop to 4 percent, the company is now paying too high of a dividend. So it can call in the 6 percent shares and issue new preferred shares that pay only a 4 percent dividend.
Holders of convertible preferred shares can swap them for common stock under conditions laid out in the prospectus. The prospectus will identify a conversion date, which is the date after which the shareholder can make the exchange, and a conversion ratio, which specifies how many shares of common stock each convertible share will be worth. The date and ratio vary among companies, and even between different series of preferred shares issued by the same company.
If a preferred share has a 6 percent dividend based on an original issue price of $25, then the share will pay $1.50 a year. The shares trade on the open market, just like common shares, but the dividend is always tied to the issue price, not the market price. The higher the market price, the lower the yield. That puts an effective cap on the value of a preferred share as an investment and, thus, on the market price. Converting preferred shares to common shares sacrifices the guaranteed dividend -- but it gives shareholders the opportunity to take advantage of the type of market price increases that are possible with common stock.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.