Adjustable Rate Preferred Stock: Everything You Need to Know

A preferred stock (or preference share) that pays out a dividend that is modified by changes in a benchmark rate is called an adjustable-rate preferred stock The dividend rate is usually adjusted quarterly, and the linked benchmark rate is predetermined when the shares are issued. The most commonly used benchmark is the treasury bill (T-bill) rate.

Features of an adjustable-rate preferred stock

The main features of adjustable-rate preferred stocks include:

1. First preference over equity shareholders

   In both fixed and adjustable-rate preferred stocks, companies first pay out dividends to preferred stockholders before paying out a dividend to equity shareholders.

2. Stable market value

   The market value of adjustable-rate preferred stocks is more stable than fixed-rate preferred stocks. The value of fixed-rate preferred stocks rises when the interest rate falls and vice versa. On the other hand, the market value of adjustable-rate preferred stocks remains largely the same because of the built-in rate adjustments, which insulate the stock value from interest rate changes.

3. Collared dividend movement

   Although the dividend rate on adjustable-rate preferred stock is floating, they usually come with ‘collars’, which limit the dividend rate movement. Collars signify ‘caps’ and ‘floors’ placed on dividend yields. The dividend rate is ‘capped’ using a cap rate to prevent the issuer from having to pay inordinately large dividends.

   Conversely, a floor rate demarcates the minimum dividend the issuer will have to pay out, irrespective of sharp interest rate drops. Adjustable-rate preferred stocks take the form of fixed-rate preferred stocks when interest rates fall outside the collar range.

How is Adjustable-Rate Preferred Stock Used?

Consistent dividend payouts and the largely fixed market value offered by adjustable-rate preferred stock make it suitable for investors seeking fixed and stable returns. At the time of company liquidation, preferred stock (adjustable-rate or fixed-rate) is given priority over common stockholders. They are also given priority over equity holders at the time of distributing dividends.

With the decrease in the benchmark interest rate, the adjusted preferred stock dividend rate falls, too. Consequently, the investors receive lesser dividends, and the stock price remains almost the same.