Retractable Preferred Shares
A retractable preferred shareholder can force the company to buy back retractable preferred shares for cash on a specified date, at a specified price. Some are issued with two or more retraction dates. The principle of retraction, or pulling back, is identical to the principle for retractable bonds and debentures, which we discussed in Chapter 6.
The holder of a retractable preferred can create a maturity date for the preferred by exercising the retraction privilege and tendering the shares to the issuer for redemption. The term soft retractable preferred refers to those retractables where the redemption value may be paid in cash or in common shares, generally at the election of the issuer.
Example
JKL Inc., Series 14, Cumulate Class A Preference Shares are retractable on the first of each March, June, September, and December at $100 per share.
Characteristics of Retractable Preferred Shares
From the standpoint of the purchaser, retractable preferreds have the following characteristics:
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Retractable Date and Price: They provide a predetermined date and price at which to tender shares for retraction. The shorter the time interval to the retraction date, the less vulnerable the stock’s market price is to increases in interest rates. A straight preferred declines in price as interest rates rise, whereas a retractable preferred will not fall significantly below its retraction price as the retraction date approaches.
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Capital Gain: They provide a capital gain if purchased at a discount from the retraction price and subsequently tendered at the retraction price.
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Market Behavior: They sell above the retraction price and at least as high as the call price when interest rates decline sufficiently.
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Action Requirement: They do not retract automatically; the retraction privilege expires if no action is taken by the holder during the election period.
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Reversion to Straight Preferred Shares: They become straight preferred shares if they are not retracted when the election period expires. If this occurs in a period of high or rising interest rates, the stock’s market value declines. The shares sell on a straight yield basis after the retraction privilege expires.
Key Takeaways
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Predetermined Retraction: Retractable preferred shares provide investors with a predetermined date and price for retraction, helping reduce market price vulnerability to interest rate increases.
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Potential for Capital Gain: Investors can achieve capital gains by purchasing shares at a discount and selling at the retraction price.
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Impact of Interest Rates: The market value can significantly vary with changes in interest rates, performing differently compared to straight preferreds.
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Active Management Required: Retraction is not automatic; investors need to be proactive during the election period to utilize this privilege.
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Reversion Risk: During periods of inaction or expiry of retraction privileges, shares revert to straight preferred status and may suffer in regions of high interest rates.
FAQs
Q: What are soft retractable preferred shares?
A: Soft retractable preferred shares are those where the redemption value may be paid in cash or in common shares, generally at the election of the issuer.
Q: What happens if I don’t retract my preferred shares during the election on retraction date?
A: If you do not take action during the election period, your retractable preferred shares may convert to straight preferred shares after the retraction privilege expires.
Q: Should I be concerned about interest rate fluctuations with retractable preferred shares?
A: Retractable preferred shares are generally less vulnerable to interest rate increases as the retraction date approaches, but declining interest rates can drive their market value above the retraction and call prices.
Glossary
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Retractable Shares: Preferred shares that can be sold back to the issuer at a predefined price on a specific date.
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Election Period: The timeframe within which holders must exercise their retraction privilege.
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Straight Preferred Shares: Preferred stock without built-in retraction or conversion features which trade mainly based on dividend yield.
📚✨ Quiz Time! ✨📚
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## What can a retractable preferred shareholder force the company to do?
- [ ] Convert their preferred shares into bonds
- [ ] Issue a dividend
- [x] Buy back their retractable preferred shares for cash on a specified date at a specified price
- [ ] Increase the interest rates on their shares
> **Explanation:** A retractable preferred shareholder can require the company to buy back the shares on a specific date and at a predetermined price.
## What term is used to describe retractable preferreds where the redemption value may be paid in cash or common shares?
- [ ] Hard retractable preferred
- [x] Soft retractable preferred
- [ ] Zero-coupon retractable preferred
- [ ] Floating retractable preferred
> **Explanation:** Soft retractable preferreds refer to those retractables where the redemption value may be paid in cash or in common shares, generally at the election of the issuer.
## Which of the following characteristics is true for retractable preferreds?
- [ ] They automatically retract on the retraction date without any action required from the holder
- [ ] They always provide a capital loss
- [x] They provide a predetermined date and price at which to tender shares for retraction
- [ ] Their market price increases as interest rates rise
> **Explanation:** Retractable preferreds provide a predetermined date and price at which to tender shares for retraction.
## What happens to retractable preferred shares if the retraction privilege expires without any action taken by the holder?
- [x] They become straight preferred shares
- [ ] They are automatically converted to common shares
- [ ] They are issued as bonds
- [ ] They are returned to the issuer
> **Explanation:** If the retraction privilege expires without any action taken by the holder, the retractable preferred shares become straight preferred shares.
## How does the market price of retractable preferreds react as the retraction date approaches, assuming the interest rates are rising?
- [ ] It increases significantly above the retraction price
- [ ] It becomes highly volatile
- [x] It does not fall significantly below the retraction price
- [ ] It aligns directly with the market interest rates
> **Explanation:** As the retraction date approaches, retractable preferreds do not fall significantly below the retraction price, even if interest rates are rising.
## What is a benefit of purchasing retractable preferreds at a discount from the retraction price?
- [ ] Access to additional dividends
- [ ] Automatic conversion to equity
- [x] Potential for a capital gain when retracted at the retraction price
- [ ] Guaranteed premiums on retraction
> **Explanation:** Purchasing retractable preferreds at a discount from the retraction price can lead to a capital gain when they are tendered at the retraction price.
## How frequently are JKL Inc., Series 14, Cumulate Class A Preference Shares retractable?
- [x] Quarterly
- [ ] Annually
- [ ] Semi-annually
- [ ] Monthly
> **Explanation:** JKL Inc., Series 14, Cumulate Class A Preference Shares are retractable on the first of each March, June, September, and December.
## When interest rates decline sufficiently, how do retractable preferreds typically trade?
- [ ] Below their retraction price
- [ ] Same as straight bonds
- [x] Above the retraction price and at least as high as the call price
- [ ] They remain unaffected
> **Explanation:** When interest rates decline sufficiently, retractable preferreds sell above the retraction price and at least as high as the call price.
## What occurs if retractable preferred shares are not retracted in a period of high or rising interest rates?
- [x] The stock’s market value declines
- [ ] The shares convert to common stocks
- [ ] The retraction period is extended automatically
- [ ] The issuer is required to redeem the shares
> **Explanation:** If retractable preferred shares are not retracted during a period of high or rising interest rates, their market value declines and they sell on a straight yield basis.
## For retractable preferred shares, which factor increases the less vulnerability of the stock’s market price to increases in interest rates?
- [ ] Increased dividend yield
- [x] Shorter time interval to the retraction date
- [ ] High market volatility
- [ ] Longer held period by the investors
> **Explanation:** The shorter the time interval to the retraction date, the less vulnerable the stock’s market price is to increases in interest rates.