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  See features of our free CDx3 Newsletter See recent preferred stock research articles from Doug K. Le Du, author of Preferred Stock Investing Test your preferred stock knowledge with these multiple-choice questions

 



 

 
 
       
 

Test your knowledge

 

 

 
   

  How confident are you in your knowledge of preferred stock investing? Test your knowledge, with these multiple-choice questions, about concepts discussed in Preferred Stock Investing, Fifth Edition, by Doug K. Le Du (Click here to download for free in PDF »).

 

 
 
 

 

 

 

 

1. How can I tell if there is strong demand for a preferred stock?


(A) The market price increases over time
(B) The company posts a big quarterly profit
(C) The market price drops by less than the dividend after the ex-dividend date
See the answer »

2. What price is used to calculate preferred stock dividends?


(A) Your original purchase price
(B) The market price on the ex-dividend date
(C) Liquidation price (usually $25 per share)
See the answer »

3. Why are preferred stocks considered lower risk than the same company's common stock?


(A) Preferred stockholders get paid their dividends before common stockholders
(B) Prices are less volatile since the dividend is known in advance
(C) Preferred dividend payments are less tied to quarterly profits
(D) Common stocks have no par price below which principal is more protected
(E) All of the above
See the answer »

4. How do I pick the highest quality preferred stocks?


(A) The prospectus specifies that the dividends are "cumulative."
(B) The preferred has a current "investment grade" rating.
(C) The issuing company has a perfect track record of never suspending a preferred dividend.
(D) All of the above.
See the answer »

5. What is the difference between a 'cumulative' and a 'non-cumulative' dividend?


(A) A cumulative dividend is one that increases each quarter; non-cumulative dividends stay the same.
(B) Cumulative dividends must eventually be paid to you while non-cumulative dividends can be skipped.
(C) Cumulative dividends can be paid at any time while non-cumulative dividends are paid quarterly.
See the answer »

6. When does the call date of a preferred stock occur?


(A) Five years after the preferred stock is first introduced.
(B) Five years after the first dividend is paid.
(C) Five years prior to the maturity date of the preferred stock.
See the answer »

7. When a preferred stock is called how much do I get per share?


(A) The then-current market price of the preferred stock shares.
(B) $25.00 per share.
(C) Your original purchase price (i.e. you get your principal back).
See the answer »

8. How do I calculate the Effective Annual Return of a preferred stock investment upon its call?


(A) Add up the total income you've earned (dividends plus capital gain) and divide by your invested amount
(B) Since the call price is $25 per share, the Effective Annual Return is the same as the annual dividend rate
(C) Calculate the quarterly internal rate of return, then compound the result for four quarters
See the answer »

9. How do I avoid purchasing a preferred stock that I can never sell?


(A) Be sure the declared dividend rate is at least 0.25% above the current 'going dividend rate.'
(B) Be sure the declared dividend rate is at least 0.5% above the current 'going dividend rate.'
(C) Be sure the declared dividend rate is at least 0.75% above the current 'going dividend rate.'
See the answer »

10. What are the three types of preferred stock?


(A) Cumulative preferreds, trust preferreds, convertible preferreds
(B) Traditional preferreds, trust preferreds, third-party trust preferreds
(C) Redeemable preferreds, tax-favored preferreds, trust preferreds
See the answer »

11. What is a 'capital treatment event'?


(A) The circus tent covering applied to a state's capital building when fighting a termite infestation.
(B) A point in time when you determine that a word's first letter should, in fact, be Capitalized.
(C) A change to the way a bank's Tier 1 Capital reserves are calculated as invoked by a recognized authority.
See the answer »

12. What is meant by a preferred stock's 'liquidation preference'?


(A) It is the price per share that a shareholder receives in the event of a call
(B) The liquidation preference is equal to one quarter's worth of dividend income
(C) Shareholders receive the liquidation preference amount in cash if the company goes bankrupt
See the answer »


Answers:

1. How can I tell if there is strong demand for a preferred stock?

The correct answer to this question is (C), the market price drops by less than the dividend after the ex-dividend date.

The Rule of Buyer/Seller Behavior (Preferred Stock Investing, page 45) tells us that the market price of a preferred stock will tend to increase, beyond where it would have otherwise, as the dividend pay date (the ex-dividend date) approaches. In a theoretical perfect market, this increase would be for the exact amount of the upcoming dividend payment.

Then, continuing our perfect market scenario, the market price would drop by exactly the amount of the quarterly dividend once the ex-dividend date passed and the process would start all over again. For example, a preferred stock that pays an 8 percent annual dividend generates $2.00 per share per year. That's $0.50 per quarter. So, in a theoretical perfect market we would expect to see the market price increase throughout the quarter, reaching an increase of $0.50 the day prior to the ex-dividend date. On the next day (the ex-dividend date) we would then expect to see the market price fall by $0.50 and the process would start over again.

But the market is never perfect, of course. Disruptive events (a Global Credit Crisis, geopolitical flare-ups) alter the behavior of buyers and sellers and motivate them to make decisions that are different than they would otherwise make.

By comparing the actual price change throughout a dividend quarter with our expected price change (the dividend amount) preferred stock investors can determine if there is strong or weak demand for a specific preferred stock.

In the case of our 8 percent preferred stock example, if the market price drops by, say, $0.20 following the ex-dividend date (rather than the expected $0.50), there is very strong demand in the marketplace for this preferred stock.

Where common stock investors frequently look at market price trends over time to gauge market demand for a common stock, preferred stock investors have a much more direct metric that actually allows us to quantify the level of market demand for a preferred stock every quarter in much less speculative fashion. Chapter 3 of Preferred Stock Investing includes actual market data and a chart that illustrates this mechanism.


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2. What price is used to calculate preferred stock dividends?

The correct answer to this question is (C), the liquidation price.

The declaration date (date that the issuing company declares the record date), ex-dividend date (set by the stock exchange) and record date (set by the issuing company) occur prior to the actual dividend payment. The payment schedule for dividends throughout the year is specified in the issue's prospectus. For a preferred stock that pays quarterly dividends there will be four payment dates listed (usually in the prospectus section titled "Dividends").

But if a payment date falls on a weekend, holiday or other non-business day the closest business day after the payment date is the date that shareholders will receive the actual dividend payment. The date of actual payment is called the distribution date.

And, for fixed-rate preferred stocks, the amount of that dividend distribution will be exactly the same every quarter, regardless of your original purchase price and regardless of the then-current market price. The dividend amount is calculated by multiplying the declared dividend rate (coupon rate) by the "liquidation price" which is usually $25.00 per share (for preferred stocks intended for individual investors).

For example, a preferred stock with an 8% declared dividend rate generates $2.00 per year in dividend income to the shareholder (8% x $25.00 = $2.00) per share. Dividing this annual amount by four gives you the quarterly dividend amount that will appear in your brokerage cash account on the distribution date, in this case $0.50 per share ($2.00 divided by 4 = $0.50).

This $25.00 value is referred to in the prospectus of a preferred stock as the "liquidation preference," an overly-confusing term that refers to what shareholders will ultimately receive in the event that the shares are liquidated (turned into cash) by the issuing company.

The issuing company can liquidate (buy back from you) your shares in two ways: (1) by retiring ("calling") the shares on or after the published call date (which usually occurs five years after the date that the preferred stock is first issued to the marketplace) or (2) allowing the security to reach its maturity date without having previously being called. In either event, the issuing company will liquidate your shares for a price equal to the liquidation preference amount as published in the prospectus.

In the meantime, each quarterly dividend will be calculated using the liquidation preference amount and paid to you on each distribution date as published in the preferred stock's prospectus.


« Back to questions

3. Why are preferred stocks considered lower risk than the same company's common stock?


(A) Preferred stockholders get paid their dividends before common stockholders
(B) Prices are less volatile since the dividend is known in advance
(C) Preferred dividend payments are less tied to quarterly profits
(D) Common stocks have no par price below which principal is more protected
(E) All of the above

When you purchase a share of a company's preferred stock you are considered to be an owner — you have "equity" in the issuing company. But unlike common stock, preferred stocks pay a fixed periodic dividend to you. You are going to receive the same dividend amount every period. It does not fluctuate, so you know, in advance, what your payments are going to be (although there is such a thing as a variable rate preferred stock but these are rare and have their own set of risks; see chapter 7 of Preferred Stock Investing). Consequently, preferred stocks are seen as lower risk than the same company's common stock.

Further, if the company is running low on cash and does not have enough to pay the dividends to both its common and preferred stock shareholders, those holding the preferred stock shares get paid first and in full before common stockholder see a dime — you have preferred status; hence the name "preferred stock."

Preferred stock dividends, being known in advance, are therefore more related to a company's cash flow than to this quarter's profits. Meanwhile, when you buy a share of a company's common stock there is no promise whatsoever of any future return. Nor is there any obligation to pay you any type of return. If the company does well and is profitable, a portion of those profits may be shared with you, or not, as determined by the company's board of directors.

Since purchasers of a company's common stock are paid their return, if any, out of the company's profits (according to how many shares you own), and these payments are at risk depending upon how well the company does, you are considered to be one of the company's owners; you have an "equity" position in the company. Generally there is no meaningful par value with common stock (AAPL common stock, for example, has par value of $0.00001 per share). Preferred stock, by contrast, typically has par value of $25 per share (the par amount may vary but $25 is the most common).

What do you give up with preferred stock? In exchange for the lower risk, fixed known dividend payments and getting to stand in line in front of common stockholders, preferred stockholders must give up their voting rights. That means that you will not be asked to vote in corporate elections or on company policy decisions.

But let's face it — unless you own hundreds of thousands or even millions of shares, no one in any corporate boardroom is waiting breathlessly for your ballot to arrive.

For most of us, giving up voting rights in exchange for the benefits of preferred stocks is a no-brainer. (Learn more about managing the risks associated with preferred stock investing in chapter 8 of Preferred Stock Investing).


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4. How Do I Pick The Highest Quality Preferred Stocks?

The correct answer to this question is (D), all of the above.

Notice that neither these criteria, nor any of the remaining CDx3 Selection Criteria from chapter 7 of Preferred Stock Investing, have anything to do with specific industries or types of businesses. We are looking for the highest quality issues regardless of where they come from.

So while relaxing these criteria may provide an investor with a different array of industries from which to choose, doing so increases investor risk.

For example, for preferred stocks from telecommunications or manufacturing to become candidates, you would have to give up the "cumulative" dividend requirement. While there are a few exceptions, preferred stocks issued by companies in these industries are generally "non-cumulative," meaning that if the issuing company misses a dividend payment to you they have no obligation to make it up in the future. Risk adverse preferred stock investors are looking for preferred stocks that are "cumulative."

In fact, it is the "cumulative" dividend requirement that saved CDx3 Investors during the Global Credit Crisis more than any other criteria. Looking at the 70 bank-issued preferreds that were trading at the time, the 13 preferreds issued by the banks that were saved from bankruptcy were all "cumulative."

Rating agencies such as Moody's and Standard & Poor's provide creditworthiness ratings for preferred stocks. These ratings have two main categories, investment grade and speculative grade. Preferred stocks that carry the investment grade rating are viewed by the rating agency as being of lower risk than those rated speculative.

While the dividend return of a speculative grade preferred stock may be higher than those rated investment grade, the CDx3 Selection Criteria favors lower risk over higher returns.

And looking for preferred stocks that are issued by companies with a solid history of consistent performance is also important when trying to identify the highest quality preferreds. Airlines provide an obvious example. If you had to choose between two preferred stocks, both cumulative and investment grade but one had been issued by a company with a history of bankruptcy and suspended dividends (e.g. Delta Airlines) and the other had not, which would you judge to be the higher quality security?

Having cumulative dividends, an investment grade rating and being issued by a company with a perfect track record of never having suspended preferred stock dividends are just three of the ten CDx3 Selection Criteria from chapter 7 of my book, Preferred Stock Investing.

With new issues being introduce, and old issues being retired, the number of preferred stocks trading every day ranges between 1,000 and 2,000. By applying the ten CDx3 Selection Criteria, preferred stock investors are left with the highest quality issues available. The resulting list is available 24/7 to subscribers to the CDx3 Notification Service in the CDx3 Preferred Stock Catalog on the subscriber's exclusive website.


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5. What is the difference between a 'cumulative' and a 'non-cumulative' preferred stock dividend?

The correct answer to this question is (B), cumulative dividends must eventually be paid (assuming the issuing company remains solvent).

The prospectus of a preferred stock will refer to cumulative dividends in one of two different ways. Most frequently, the term "cumulative" will actually be used in the description of the dividend payments. Less frequently, however, the prospectus, rather than use the term "cumulative" and assume that the reader knows what it means, will use a explanation instead. In this case, the dividends will be described as ones that can be "deferred" (as opposed to being "suspended").

With a cumulative dividend, in the event that the issuing company is unable to make the quarterly dividend payment to you, the dividend will be deferred. The company's obligation to pay you does not go away; they still owe you the money. And until they pay you, no dividends can be paid to common stock shareholders; you get paid first.

With a non-cumulative dividend, the issuing company is allowed to suspend your dividend payment. So if they miss a dividend payment to you, you're out.

The highest quality preferred stocks ("CDx3 Preferred Stocks") are preferred stocks that carry the cumulative dividend requirement. Interestingly, the 57 preferred stocks issued by the Big Banks that failed during the Global Credit Crisis were all non-cumulative, while the 13 preferreds issued by the Big Banks that dodged failure by being acquired were all cumulative.

This question also provides an opportunity to clarify a common misconception. You will often read or hear reference to cumulative and non-cumulative preferreds as being two types of preferred stock.

This is incorrect. There are only three types of preferred stock (traditional, trust and third-party trust) as defined by their accounting treatment. Whether or not a preferred stock has a cumulative dividend is a characteristic of the security; it does not define another type (see Preferred Stock Investing, chapter 2 "Creating A New Preferred Stock").


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6. When does the call date of a preferred stock occur?

The correct answer to this question is (A), five years after the preferred stock is first introduced.

For the first five years of a preferred stock's life, the issuing company is required to continue paying you the dividends specified within the issue's prospectus (see the exception below). Even if prevailing dividend rates in the U.S. economy change after the preferred stock shares are issued, the issuing company must continue to pay you your dividends as specified in the prospectus.

But once the call date arrives, five years after introduction, the issuing company regains the right to purchase your shares back from you. Whether or not the issuing company calls a preferred stock issue is often determine by whether or not the company can save dividend expense by doing so.

And the savings do not have to be as much as you might think. In fact, if the issuing company can save as little as .375% by issuing a new preferred stock at a lower dividend rate and use the proceeds to call an older, higher-paying issue, there is a 91% chance that they will do so (see Preferred Stock Investing, pages 211-212).

Section 171 of the Wall Street Reform and Consumer Protection Act provides another reason that a company will call a preferred stock. This section of the Act eliminates the primary reason that Big Banks issue, and continue to pay dividends on, trust preferred stocks (one of the three kinds of preferreds and the one that is most favored by banks). Starting January 1, 2013 Big Banks will no longer be allowed to count the value of their trust preferred stocks toward their "Tier 1 Capital," a measure of their reserve strength.

Because of this new law, it is highly likely that our Big Banks will call their trust preferred stocks as their respective call dates arrive, starting with trust preferred stock issues with call dates on or before January 1, 2013. Shareholders will receive $25 per share in the event of a call. So investors who purchase shares today for less than $25.00 per share position themselves for a nice capital gain, in addition to the great dividend income, in the event of a call.

Exception: As of October 15, 2011 there were five high quality Big Bank TRUPS (i.e. TRUPS issued by our Big Banks that meet the selection criteria from chapter 7 of Preferred Stock Investing) that can be called prematurely; that is, they can be called at any time regardless of their published call date. The prospectus of these securities includes a provision that allows the bank to issue a call if the government changes the rules regarding how Tier 1 Capital is calculated (which is exactly what happened when the Act was signed into law in July 2010). There were originally nine such TRUPS but four of those have either been prematurely called already or have now reached their published call date. That leaves five high quality Big Bank TRUPS that can be prematurely called at any time.

For a list of the targeted trust preferred stocks that are currently selling for less than $25 per share, including the Big Bank TRUPS that can be prematurely called, please consider subscribing to the CDx3 Notification Service today at www.PreferredStockInvesting.com.


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7. When a preferred stock is called how much do I get per share?

The correct answer to this question is (B), $25.00 per share.

It is for this reason that those following the preferred stock investing method described throughout my book, Preferred Stock Investing, always make their purchases for less than $25 per share.

Preferred Stock Investing explains how and when to do so regardless of market conditions.

By always purchasing your preferred stock shares for less than $25 each, you set yourself up for a capital gain in the event of a call by the issuing company on top of the great dividend income that you'll be earning in the meantime.

Since section 171 of the Wall Street Reform Act (by reference) disallows Trust Preferred Stocks (one of the three types of preferred stocks, see Preferred Stock Investing chapter 2) from being included in the capital reserves that Big Banks have to keep on hand (as measured by the Tier 1 Capital calculation), it is extremely likely that these banks are going to be calling their Trust Preferred Stocks as soon as possible (paying all holders $25 per share). Comerica, Fifth Third, KeyCorp and Wells Fargo have already done so.

Knowing that (1) you are going to receive $25.00 per share in the event of a call, (2) a call is extremely likely, (3) which specific preferred stocks are going to be involved and (4) the exact date that those preferred stocks will become callable, provides a very unique opportunity that preferred stock investors should consider, especially since many of these targeted Trust Preferred Stocks are currently providing annual dividend yields of about 7%.

For a list of the targeted Trust Preferred Stocks that are currently selling for less than $25 per share, please consider subscribing to the CDx3 Notification Service today.


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8. How do I calculate the Effective Annual Return of a preferred stock investment upon its call?

The correct answer to this question is (C). What makes this calculation more tricky than it would otherwise be is that you have to include something called the "time value of money."

The time value of money is a well known, intuitively obvious concept that is very easy to illustrate: if I were to offer you $100 today (free and clear, no strings attached) or the same $100 delivered to you 10 years from now, which would you pick?

When it comes to the value of a buck, sooner is always better. That's the time value of money. Having the same money sooner has more value than having the same money later. The reason, of course, is that if you have the money now, versus later, you have the opportunity to do something with it such as invest it and generate additional returns (which you could also then reinvest in compounding fashion).

That's why answer (A) is incorrect. Simply adding up your income and dividing it by the amount you have invested just gives you the percentage of your investment that you have realized in the form of additional returns. It does nothing to accommodate the time value of money.

Answer (B) is also incorrect because it not only does not capture the time value of money that you realize by receiving periodic dividend payments over the life of the investment (purchase date to call date), but it assumes that you have no capital gain or loss (i.e. that you originally paid $25 per share, the same as the call price). My book, Preferred Stock Investing, shows you how to always purchase your CDx3 Preferred Stock shares for less than $25, regardless of market conditions, increasing your chances to pile a capital gain on top of your dividends.

To calculate your actual EAR, you first have to calculate your return for a quarter (the period over which you receive the dividend) using the Excel RATE function. The result is called the internal rate of return. Then compound this quarterly value for four quarters using this formula: [ (1 + r)^4 ] – 1, where r is the quarterly internal rate of return value from the RATE function.

The result is your Effective Annual Return.

The exclusive website for subscribers to the CDx3 Notification Service provides a very robust Excel-based What-If EAR Calculator. Using the calculator, subscribers can just plug in the particulars of their preferred stock (purchase date, purchase price, dividend rate, etc.) and instantly see the EAR, dividend yield, quarterly cash income and many other key values. The calculator also allows subscribers to test trading strategies such as selling one issue and using the proceeds to buy another, calculating break-even price points and impact to income in advance.

The CDx3 Special Report "Calculating Your Rate Of Return" walks you through the entire calculation, step by step, including the setup of the Excel RATE function for your preferred stock. Knowing how to calculate your EAR is essential for preferred stock investors.


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9. How do I avoid purchasing a preferred stock that I can never sell?

The correct answer to this question is (B): Be sure the declared dividend rate is at least 0.5% above the current 'going dividend rate.'

Knowing the answer to this question requires an understanding of the Rule of Rate/Price Opposition (Preferred Stock Investing page 53), one of the Three Rules of Market Price Predictability.

This Rule says that the dividend rate offered by new preferred stock issues and the market prices of previously introduced, older issues will move in opposite directions. Rates up, prices down and vice versa. Keep that in mind as I walk you through this explanation.

When a new preferred stock is introduced it is priced at $25.00 per share. The declared dividend rate is set at a level where there is a market for it at $25. Let's say that the "going dividend rate" of a new preferred stock is 6.0% today and you purchase it for $25.00 per share. Now a year goes by and rates have gone up to, say, 7.0%. If, a year from now, $25 gets you 7.0%, what do you think is going to happen to the market price of your 6.0% payer? It will be less than $25, of course. Rates up, prices down.

Using the Rule of Rate/Price Opposition, the market price of your 6.0% payer has nowhere to go but down once rates bounce off the bottom.

Also, the issuing company of a 6.0% preferred stock is unlikely to ever call it (buy it back from you) since 6.0% is very cheap money to them.

To protect yourself from purchasing a preferred stock that you can never sell (without a capital loss), preferred stock investors should give themselves a cushion. Historically, a cushion of about 0.5% has seemed adequate. When rates head back up you'll have some warning and still have time to sell.

But if you purchase a preferred stock at the bottom of the rate barrel, you are very likely to be holding, and collecting its quarterly dividends, for a very long time. Stay off the bottom by giving yourself of 0.5% cushion.


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10. What are the three types of preferred stocks?

The correct answer to this question is (B), traditional preferreds, trust preferreds, third-party trust preferreds.

Any of these three types can have a variety of characteristics that define something about the dividends, the structure of the issuing company or the tax treatment of the dividends (to either the issuing company or the shareholder).

For example, the term "cumulative" describes an obligation on the part of the issuing company to pay back any skipped dividends to shareholders. If a preferred stock's prospectus includes the cumulative dividend provision, the issuing company's obligation to pay you any skipped ("deferred") dividends accumulates; they still owe you the money. There are traditional preferreds, trust preferreds and third-party trust preferreds that have cumulative dividends and there are others that do not. But the term "cumulative" is a characteristic of the preferred stock's dividend payments to you; it is not a type of preferred stock.

"Convertible" preferred stocks are those that, at some point in time and under conditions specified within the prospectus, convert to shares of the issuing company's common stock. Any of the three types of preferreds can include this provision in their prospectus so being convertible is not a type of preferred stock; it is a characteristic.

"Redeemable" preferreds (also called "callable" preferreds) are those that, on a certain date in the future as declared within the prospectus, can be called (bought back from you) by the issuing company. Most preferred stocks, regardless of type, are redeemable but some can only be redeemed upon the arrival of their maturity date.

"Tax-favored" preferred stocks are those whose dividends qualify for 15% tax treatment under the 2003 Tax Relief Act. But again, these are not a separate type of preferred stock. The tax-favored notation makes a reference to a characteristic of the preferred stock's dividend tax treatment, not a type of preferred stock. All tax-favored preferred stocks are traditional preferred stocks and no tax-favored preferred stock has ever been able to meet the ten risk-lowering preferred stock selection criteria from chapter 7 of Preferred Stock Investing.

Traditional preferred stocks have been around for many decades and were originally primarily issued by utilities, but that has not been the case for almost thirty years. When you buy shares of a traditional preferred stock you are buying an non-voting equity position in the issuing company.

With trust preferred stocks (TRUPS), investors are actually purchasing preferred stock shares in a trust company that is owned by a parent company (usually a bank but some TRUPS are issued by insurance companies). The parent company sets up the trust company and sells the trust company a bond (like a loan). The trust company collects interest from the parent company on that bond and uses that cash to pay your dividends.

A third-party trust preferred stock is similar to a TRUPS but the underlying bond held by the trust company is not issued by the parent company. Rather, the parent company is a brokerage firm that buys a bond on the open market and puts that bond into a trust company as its sole asset. The trust company collects interest on the bond from the bond's issuing company and uses that cash to pay dividends to investors who have purchased shares of preferred stock in the trust company.

The distinctions between these three types of preferred stocks are largely irrelevant to you, the investor. The differences exists primarily to meet the tax strategy or regulatory needs of the issuing company. While all three types can have a variety of characteristics, there are only three types.


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11. What is a 'capital treatment event'?

The correct answer to this question is (C), a change to the way a bank's Tier 1 Capital reserves are calculated as invoked by a recognized authority.

Banks are required to keep a certain amount of their capital in reserve in case of some type of disaster. The formula for Tier 1 Capital, a way of measuring bank reserves closely watched by bank regulators, is set by the U.S. government. The formula defines how banks are to treat their capital with respect to measuring reserves.

Changes to the treatment of a bank's capital as it relates to the Tier 1 Capital metric is referred to as a "capital treatment event" in preferred stock prospectus language, especially bank-issued trust preferred stocks (TRUPS).

While there are a few rare exceptions (see the Last Month's CDx3 Investor Results article in the June 2011 issue of the CDx3 Newsletter) common TRUPS prospectus language says that the bank can prematurely redeem (call) the TRUPS shares within 90 days from the date of either an announcement of a capital treatment event or the actual implementation of such an event. That creates two 90 day windows of opportunity within which the bank is allowed to prematurely call their TRUPS.

Let's take a look at the actual prospectus language of a real bank-issued trust preferred stock as it relates to a capital treatment event (shortened for presentation here).

"...prior to [the call date], at any time within 90 days of the occurrence of a...capital treatment event...[the bank] may redeem the [TRUPS], in whole but not in part..."

On rare occasions the phrase "...within 90 days..." is omitted, making the TRUPS callable at any time if a capital treatment event occurs. Later in the same prospectus the term "capital treatment event" is defined as:

"A capital treatment event means [the bank]'s reasonable determination that, as a result of the occurrence of any amendment to, or change (including any announced prospective change) in, the laws (or any rules or regulations thereunder) of the United States or any political subdivision thereof or therein, or as a result of any official or administrative pronouncement or action or judicial decision interpreting or applying such laws, rules or regulations, which amendment or change is effective or which pronouncement, action or decision is announced on or after the date of issuance of the Trust Preferred Securities, there is more than an insubstantial risk that [the bank] will not be entitled to treat an amount equal to the aggregate liquidation amount of the Trust Preferred Securities as Tier 1 capital..."

Once the Wall Street Reform Act was signed into law on July 21, 2010, the U.S. government was essentially announcing that it would be changing the Tier 1 Capital formula. The actual change happens on January 1, 2013. These two dates (the signature on July 21, 2010 and the implementation on January 1, 2013) are important to preferred stock investors since both generally qualify as "capital treatment events" as seen in the above example.

For Big Bank TRUPS that include these common provisions, the first 90 day window of opportunity for the bank to prematurely call its TRUPS, triggered by the signing of the Act, closed on October 19, 2010 so is no longer of any concern. The second window opens on January 1, 2013 so expect some Big Bank TRUPS to be called within 90 days of that date.


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12. What is meant by a preferred stock's 'liquidation preference'?

What is meant by a preferred stock's 'liquidation preference'?

The correct answer to this question is (A), the liquidation preference is the price per share that a shareholder receives in the event of a call.

Generally, the liquidation preference of preferred stocks ranges from $25 to $1000 depending on which type of investor the issue is intended for. Preferred stocks with a $25 liquidation preference are aimed at individual investors while issues with a $50 or $100 liquidation preference are positioned to attract institutional investors. The liquidation preference of the TARP preferred stocks that banks issued to the U.S. Treasury was $1,000 per share.

The liquidation preference of a preferred stock is declared within the prospectus on file with the SEC as is the call date of the security. Once the call date arrives, the issuing company regains the right to purchase your shares back from you. In the event that they choose to do so they are obligated to pay you an amount equal to the published liquidation preference for each share that you own.

For this reason, the market price of a preferred stock starts to trend toward its liquidation preference as the call date approaches if the market believes that conditions favor a call. This is the Rule of Call Date Gravity from Preferred Stock Investing (page 59).

Individual investors typically purchase preferred stocks that have a $25 liquidation preference. In the event of a call, $25.00 per share will show up in your brokerage cash account and your shares will no longer appear in your holdings. It is for this reasons that preferred stock investors who are following the preferred stock investing method described throughout Preferred Stock Investing always purchase their shares for less than $25.00 each.

Purchasing your shares for less than the liquidation preference provides two benefits to investors: (1) you add a layer of principal protection to your investment and (2) you position yourself for a capital gain in the event of a call. As itemized in chapter 15 of Preferred Stock Investing, adding on a capital gain to the great dividend income that the highest quality preferred stocks earn generally pushes your Effective Annual Return over 10 percent.


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