What is Redeemable Preferred Stock?

Redeemable preferred stock is a type of preferred stock that allows the issuer to buy back the stock at a certain price and retire it, thereby converting the stock to treasury stock. These terms work well for the issuer of the stock, since the entity can eliminate equity if it becomes too expensive. For example, a business issued redeemable preferred stock at a 6% dividend rate, but now finds that interest rates have dropped substantially. It can now issue preferred stock at a 4% dividend rate, and elects to do so by redeeming the original shares and replacing them with the 4% shares.

Understanding Redeemable Preferred Stock

The redemption feature tends to set an upper limit on the market price of the stock, since there is little point in bidding the price of a share above its redemption price. If the market price of this type of stock were to exceed the redemption price and the issuer were to redeem it, the holder of the stock would lose the difference between the market and redemption prices.

The redemption feature essentially places redeemable preferred stock somewhere on the continuum between equity and debt. It pays dividends, as do other forms of equity, but it may also be bought back by the issuer, which is a characteristic of debt.

In all other respects than the redemption feature, this type of stock matches the features of most types of preferred stock; that is, it pays a fixed dividend prior to any distributions to the holders of common stock. This dividend payment is usually cumulative, so that any suspended payments must be paid by the issuer before it can make any distributions to the holders of its common stock. Also, if the issuing entity is liquidated, the holders of preferred stock are paid off before payments to common stockholders are addressed.

There may also be a provision in redeemable preferred stock that the issuer can only buy back this type of stock on or after a certain date.

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Advantages of Redeemable Preferred Stock

There are several advantages for the issuers of redeemable preferred stock, which are as follows:

Equity reduction option. The redemption feature allows an issuer to eliminate excessively expensive equity, which reduces its cost of capital.
Avoids adding common stock. This stock type allows a business to raise equity capital without watering down the interests of those holding common stock.
Presents a more flexible capital structure. This type of stock gives the issuer the option to adjust its capital structure in the future by redeeming the stock.

There are also several advantages for those who invest in redeemable preferred stock, which are as follows:

Potential gains from the call premium. The feature may also be beneficial to investors, if the issuer must pay a call premium when it buys back stock. A further form of protection for investors is the presence of a call date, which is the earliest date on which the stock can be bought back by the issuer. If the call date is a number of years in the future, then investors may be able to benefit from high dividends in the meantime.
Presence of fixed dividends. Preferred stock typically pays out a fixed dividend amount, which has priority over any dividends paid to the holders of common stock.