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Author: joelcorley Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 50  
Subject: Re: Anyone home? Date: 6/12/2011 11:39 PM
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Rayvt,

You wrote, A preferred stock is essentially a bond that trades like a stock.

This is an over-simplification.

Quite a large percentage of the exchange traded preferred stock is essentially a bond that trades like a stock. But you can't just assume that they all are, as a novice with preferred stocks might.

All preferred stocks are part of the capital structure of a corporation or a trust. Preferred stock has a senior security interest to common stock, but it's security interest is usually subordinate to any other obligations of the corporate entity - except for items such as other preferred stock issues that are on par. (BTW, this fact can prompt credit rating agencies to lower the credit worthiness of some preferreds compared to that issuer's other outstanding bond issues.)

Preferred stock of a trust is often the most senior security. Therefore, it has the most senior interest in the assets of that trust. The common stock is often held by the issuer, but often the issuer receives little or no additional value for holding the common stock of the trust - though this is not always true as some trusts actually pay dividends on their common, even though they are closely held by the issuer. However, should the trust fold or become insolvent, the assets must first go to satisfy the preferred shareholders, which is what is meant by a senior security interest. Usually these assets are a set of bonds and possibly other assets.

Preferred stock of a corporation is often subordinate to all types of other debt obligations. Also corporate preferred stock often has no maturity date and the dividend is not a mandatory obligation of the company. However, failure to pay the dividend means they cannot pay dividends on other preferreds with an equal security interest nor on common. Also, most preferred issues have covenants that require the issuer to pay dividends or risk giving significant voting rights to the preferred shareholders ... and risk those shareholders remove the board of directors as a consequence.

Finally, there are a number of hybrid preferred securities available. Convertible preferreds in particular are securities that are a combination of debt-like security and stock warrant. With a stock warrant attached, the preferred can trade a lot like the common stock if the warrant is at or above the money. Convertibles come in two flavors - mandatory and on-demand. Mandatory convertibles will convert whenever the necessary conditions are met, while on-demand convertibles are converted at the investor's discretionary. Also some hybrids have interest rate (or other types of) swaps that can make the issue's rate variable (usually tied to some index).

The complexities of preferreds make it a potentially treacherous path for the novice. Study needs to be undertaken for every issue considered and you need to understand the risks and potential behavior of the issue before you buy. Failure to do so could result in some nasty surprises.

With that said, I think there can be significant value found in preferreds, if you know what you're looking at.

- Joel
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