Adjustable-rate Preferred Stock

Marchmont Utilities has two $100 par preferred issues outstanding. Series C pays a fixed $5.00 annual dividend. Series D pays a dividend that resets every quarter to a stated spread over a short-term Treasury benchmark. Market interest rates then rise sharply and remain higher. Which statement is correct?

1. A.Both issues should decline by roughly the same percentage, because both are perpetual instruments.Incorrect. Perpetual maturity alone does not determine price sensitivity; the behavior of the dividend does. A resetting dividend keeps the floater's yield near market without a large price move.
2. B.Series C should hold closer to par, because its dividend is contractually fixed and cannot be reduced.Incorrect, and it is backwards. A fixed dividend that cannot rise with the market is exactly why Series C's price must fall to deliver a competitive yield.
3. C.Series D should fall further than Series C, because the uncertainty of its dividend makes it the riskier holding.Incorrect. Income variability is not the same as price risk. The reset feature is what protects Series D's price; the investor trades income certainty for price stability.
4. D.Series D's market price should hold much closer to $100 than Series C's, because its dividend resets toward prevailing rates.Correct. Quarterly resets keep the floater's yield in line with the market, anchoring its price near par, while the fixed-rate perpetual must reprice downward substantially.

Why: A fixed-rate perpetual preferred behaves like a very long duration bond: with no maturity and a frozen dividend, the only way its yield can rise to match the market is for its price to fall, and it can fall a long way. An adjustable-rate (floating-rate) preferred resets its dividend toward prevailing rates every quarter, so its yield tracks the market without a large price move. Series D's price should therefore stay much nearer $100 while Series C's price declines materially.

A utility has two preferred issues outstanding with identical par values, identical credit ratings and no call in the near term. One pays a fixed 6 percent dividend. The other pays a dividend that resets every quarter against a short-term benchmark rate. Market interest rates then rise sharply. What happens to the two market prices?

1. A.Both fall by roughly the same amount, since both are perpetual preferred securities of the same issuer.Wrong. Perpetual form matters only when the payment is fixed; a resetting dividend absorbs the rate change.
2. B.The adjustable-rate issue falls further, because investors dislike the uncertainty of a floating dividend.Wrong. The floating dividend is what keeps the security at a market yield and stabilizes its price.
3. C.The fixed-rate issue falls significantly because its fixed dividend must be repriced to the higher market yield, while the adjustable-rate issue holds much closer to par because its dividend resets upward.Correct. Fixed payment means the price adjusts; resetting payment means the dividend adjusts instead.
4. D.Both rise, because preferred dividends are a fixed obligation of the issuer that becomes more valuable as rates climb.Wrong. Preferred dividends are not a debt obligation, and a fixed income stream loses value, not gains it, when rates rise.

Why: A fixed-rate preferred is economically a perpetual stream of fixed payments, so its price must fall far enough for the fixed dividend to produce the new, higher market yield. Because the stream never matures, the price sensitivity is severe. An adjustable-rate preferred solves that problem by moving the dividend rather than the price: when the benchmark rises, the next quarterly dividend rises with it, so the security continues to yield a market rate and its price stays comparatively close to par. The stability is not perfect, since a floor or a cap in the reset formula, or a change in the issuer's credit, can still move the price.