Floating-rate preferred stock

savio13

MP Guru
Straight preferred stock is a perpetual security where the dividend can be omitted by the issuer when its financial conditions deteriorates. For these reasons, usually we do not think of it as being suitable for marketable security portfolio of a corporation. However, the corporate investors gains a considerable tax advantage, in that 70 percent of the preferred stock dividend is exempt from federal taxation (in U.S.A.). (The full dividend is subject to state income taxation). Floating-rate preferred stock, as the name implies, provides a yield which goes up or down with money market values. It also permits the corporate investor to reap the advantage of the 70 percent dividend is exempt from federal tax purposes. One product in this vein is money market preferred stock (MMP). How does it work?

With MMP, an auction is held every 49 days. This provides the investor with liquidity and relative price stability as far as interest rate risk goes. It does not perfect the investor against default risk. The new auction rate is set by the forces of supply and demand in keeping with interest rates in the money market. A typical rate might be 0.75 times the commercial rate, with more creditworthy issuers commanding an even greater discount. As long as enough investors bid at each auction, the effective maturity date is 49 days. As a result, there is little variation in the market price of the instrument over time. The auction where there are insufficient bidders, there is default rate for one period that is frequently 110 percent of the commercial paper rate. In addition, the holder has the option to redeem the instrument at its face value.

These provisions are attractive to the investor as long as the company is able to meet the conditions. If the company should altogether default, however the investor loses. There have been only a few instances of failed auctions and default.
 
Top