Preferred shares and hybrid bonds: fixed dividends, calls, deferral and ranking

What you will learn

• How preferred shares and hybrid bonds differ from ordinary shares and senior bonds.
• What call dates, coupon resets, cumulative and non-cumulative deferral mean for your income.
• How to calculate current yield and yield to call, and when each applies.
• The ranking of claims in a bankruptcy, including the special case of bank AT1 bonds.

Explanation

Bond pricing and yield to maturity were covered in the course Bonds & Fixed Income in Depth; preferreds and hybrids use those tools but add equity-like features.

A preferred share in the US sense is a security with a fixed par value, usually 25 dollars, that pays a fixed or floating dividend before any dividend on ordinary shares. It normally has no votes and no maturity, but the issuer can call (redeem) it at par after a date, typically five years from issue. If the dividend is cumulative, missed payments must be paid before common dividends resume; if non-cumulative, they are lost forever. Bank preferreds are almost always non-cumulative. German "Vorzugsaktien" are different: non-voting ordinary shares with a slightly higher dividend, not fixed-income instruments.

A corporate hybrid bond is a very long-dated or perpetual subordinated bond issued by a company (utilities, telecoms and carmakers are frequent issuers in Europe). It has a first call after 5 to 10 years, after which the coupon resets to a reference rate (for example the 5-year swap rate) plus the original spread. The issuer may defer coupons, usually cumulatively, as long as it pays no share dividend. Rating agencies typically count half of a hybrid as equity, which is why companies issue them.

Additional Tier 1 (AT1) bonds, or contingent convertibles (CoCos), are perpetual bank bonds with non-cumulative, discretionary coupons that are written down or converted into shares if the bank's core equity (CET1) ratio falls below a trigger (often 5.125 or 7 percent) or the supervisor declares the bank non-viable. In March 2023, Credit Suisse AT1 bonds of about 16 billion Swiss francs were written down to zero while shareholders received UBS shares, showing that AT1s can rank below equity in practice. In the EU they are usually issued in denominations of 100,000 or 200,000 euros, which keeps most private investors out.

Ranking in bankruptcy (highest claim first): secured debt → senior unsecured bonds → subordinated (Tier 2) bonds → hybrids and AT1 → preferred shares → ordinary shares. Preferreds and hybrids recover something only after every bond is paid in full, which in most defaults means very little.

Yield measures. Current yield = annual payment / price. Yield to call (YTC) treats the call date as maturity and solves for the rate that discounts coupons and par to today's price. Above par, use YTC; below par, also read the reset coupon.

Worked example

Hypothetical example: fees, spreads and taxes excluded.

Case 1 – preferred share below par. Par 25 dollars, dividend 6 percent = 1.50 dollars a year, price 23.00 dollars, callable at par in three years.

Step 1: current yield = 1.50 / 23.00 = 6.52 percent.

Step 2: yield to call. Find r such that 1.50 / (1 + r) + 1.50 / (1 + r)^2 + (1.50 + 25) / (1 + r)^3 = 23.00; a spreadsheet gives r ≈ 9.17 percent. But the issuer has no reason to call a 6 percent security it cannot refinance more cheaply, so plan on 6.52 percent.

Case 2 – preferred share above par. Same security at 26.50 dollars, callable in one year. Current yield = 1.50 / 26.50 = 5.66 percent, but YTC = (1.50 + 25.00) / 26.50 − 1 = 0.0 percent. The issuer will call because it can refinance, and the buyer earns nothing.

Case 3 – corporate hybrid. Nominal €1,000, coupon 4 percent, price €940, first call in five years, reset to 5-year swap plus 3.0 percent. Current yield = 40 / 940 = 4.26 percent. YTC (solving for five years) ≈ 5.40 percent. If the swap rate at reset is 2.5 percent, the new coupon is 5.5 percent; the issuer calls only if a new hybrid would be cheaper. Otherwise you own a perpetual 5.5 percent instrument that may trade below par for years.

Common mistake

Practice activity

On paper: a preferred share has par 25 dollars, a 5.5 percent dividend (1.375 dollars a year) and trades at 22.00 dollars; it is callable at par in four years. (a) Calculate the current yield. (b) Estimate the yield to call by testing 8 percent and 10 percent. (c) State whether you should expect the call, and why.

Key takeaways

• Preferreds and hybrids rank just above ordinary shares; non-cumulative payments can be lost permanently.
• Above par, use yield to call; below par, use current yield and read the reset terms.
• The call is the issuer's option: it happens when it is cheap for them, not when it suits you.
• Bank AT1 bonds can be written down or converted before shareholders are wiped out, as the Credit Suisse case in 2023 showed.

Next step

Lesson 7 looks at covered-call and option-income ETFs, which manufacture a high distribution from option premiums and give up part of the upside in return.