 Personal Finance PowerPoint Presentation, Adjustable Rate Preferred Stock, or ARPS, ARPS. Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia, Adjustable Rate Preferred Stock, ARPS, which you can find online. Take a look at the references, resources, continue your research from there. This by Adam Hayes, updated October 31st, 2021. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investment. That being the fixed income, typically bonds, the equities, typically the common stocks. Now we're looking at the preferred stock and we're looking more specifically, adjustable rate preferred stock. But let's first just think about the preferred stock that we thought about in prior presentations, noting that it technically falls on the equity side of things, but functionally falls somewhat in the middle between the fixed income and the equity side of things. So let's give a quick recap. The bonds we can think of as in essence, us loaning money to the issuer of the bond, typically being a corporation or a government entity in return for the fixed income of generally the interest payments, which are going to be generally fixed and determined by the bond itself. And if the company was to not pay the interest payments, they would be defaulting, which would not be good for the company. Then we also have the maturity payment we've received at maturity of the bond. And then if we think about the common stock, not preferred stock, but first the common stock, noting that's an ownership in the company, companies being separate legal entities, separate legal entities, which have shares broken out that are all kind of the same in nature. Most of the companies we looking at are publicly traded companies, meaning they're trading on public exchanges, making it easier for individual investors to be investing in them. When we're talking about the preferred stock then that's going to be stock that is going to be issuing out typically dividends in the format of the preferred stock at a more kind of regular basis. That's why they're similar to bonds in nature. So they're not as strong as the bonds in their fixed income nature because if the company defaulted on the bonds, they would often always be defaulting. If they didn't pay the interest payments, there are certain conditions where they might not pay the preferred stock out, but they have to pay the preferred stock before the dividends on the preferred stock. That is before they pay any dividends to the common stock. That's why it has that name of preferred stock, not to indicate that the preferred stock is better than common stock per se, but it has its own uses, its own characteristics, which are different than the common stock side of things. Okay, keep in that in mind. What is adjustable rate preferred stock then? ARPS, adjustable rate preferred stock, ARPS is a type of preferred stock where the dividends issued will vary with a benchmark, most often a T-bill rate. So note what dividends are. Remember that dividends are going to be the payments of the retained earnings going out to the owners. That being the equity people, typically common stocks is what we first think, but also the preferred stock here. Now, note when we have a sole proprietorship or a partnership, those dividends are similar to what we would call draws. If I owned my own business sole proprietor, we would make money or a partnership, we would make money. The partners would be drawing out the money as needed for personal use. That can't happen in the same way in a corporation because all the stocks need to be the same and therefore you can't have one stock pulling out more money than another stock because they need to be uniform. Therefore, the determination of how much dividends are going to be paid out or determined by the company, the board of directors and the management of the company are going to determine how much they're going to be paying out in the form of the dividends. So within the adjustable dividends, which are kind of more fixed in nature typically, they might be tied to some other activity, a benchmark here such as the T-bill rate, and that means that they can vary along with the T-bill. So there's some flexibility with them, similar kind of thing that you might see for a fixed income type of tool because they're similar in nature to fixed income. Okay, so the value of the dividend from the preferred share is set by a predetermined formula to move with rates and because of this flexibility, preferred prices are often more stable than fixed rate stock preferred stocks. So understanding adjustable preferred stock ARPs. The preferred category of stocks is often considered more secure than common shares as they will be one of the first of the equity holders to receive dividend payments in the event of the company's liquidation. So note that the common shares are, they have their pros and cons and the common shares have more volatility. So on the upside, if things got better, the common shareholders would typically benefit from the value of the shares going up and possibly dividends going up on the common share side of things. However, if there's a downturn, the common shares could have more problems, right? If there's bankruptcy, for example, company liquidates goes out of business, then the preferred shareholders get paid before the common shareholders. That's why they're more secure and less risky in that way. But along with that, you typically have less upside on the growth side. So there is often a limit to the amount the rate can change on the dividends adding further security to the issue. So they're tied to the benchmark, but they also might put some upper and lower limits on how much fluctuation even if the benchmark changes drastically might not change so much here, given the feature that's be added. Also, adjustable preferred shares have dividends that periodically reset to match prevailing interest rates or other money market rates, usually on a quarterly basis. The stability of the market value of adjustable preferred stocks with respect to dividend payouts makes these securities extremely attractive to conservative investors who are looking for reliable income sources as well as the preservation of their capital. So obviously, when you're looking for income to be paid out, you might be investing that might be people closer to retirement, for example, people that want to be living off of the income that's being provided by their investments as opposed to their working years when you might be living off wages and then trying to grow your investments. And so in this case, so you might get a steady kind of return then that could go up possibly as rates kind of go up naturally because they're tied to the benchmark. So special considerations, adjustable preferred stocks share most of the same upside and downsides associated with non-adjustable or fixed rate preferred stock. So you got terms here that you might be familiar with with like they're kind of similar in nature to say like a mortgage type of situation if you were on the other side of the table trying to finance like a home and you have the adjustable or fixed rate on the loan on the other side of the table in that case. So in both cases, corporations must first pay out dividends to preferred stockholders before paying out dividends to common stock shareholders. That's the same under both kinds of preferred stock. But there are some key differences between adjustable preferred stocks and their non-adjustable counterparts. There are also some negatives, ramifications associated with adjustable preferred stock dividend rates. Namely, since adjustable preferred stock dividend rates are tied to a specific reference interest rate for index when the reference rate falls, so does the APS dividend rate. So obviously if you're investing in a dividend that has an adjustable rate, note that you're kind of expecting you think maybe the rates might go up in the future and if they went up because of inflation and so on and the rates might increase then you would like your investment to be increasing similarly. But obviously if the rates went down, the index went down that could negatively impact the amount that you're going to be receiving on the return. And that kind of works opposite to the situation when you're looking at rates on the other side of the table like if it was an adjustable mortgage versus a fixed rate mortgage, right? Okay, so consequently an investor should receive smaller dividend payouts and the price of the stock shows little change with these securities unlike fixed rate preferred stocks whose price rise when interest rates decline. So clearly the fixed rate securities, you now have a locked in rate. So if interest rates decline, they're still going to be paying out that rate so you would think that the prices for them would rise. So boundaries in place adjustable preferred stocks have set parameters called callers which are essentially caps and floor placed on dividend yields. A floor of the minimum dividend yield and APS will pay out hold strong even if interest rates drop below the floor figure. So although they're tied to the index, you've got this floor which will which will be kind of a limit. So contrarially a cap limits the maximum dividend yield payout naturally investors like floors and dislike caps. So clearly if you're getting a payout, you would like to say hey even if the index goes below this level we're still going to give you this much. I like that as an investor. On the cap side of things, it's saying well even if the index spiked all of a sudden for whatever reason we're only going to pay you this amount. It's like I don't like that. Why don't you pay me what the index says, right? So adjustable preferred stocks behave similarly to fixed rate preferred stocks when interest rates fall on the other side of the color of the color range. Auction rate arcs. Some adjustable preferred stocks use periodic auctions to reset dividend yield where current and potential shareholders participate in an auction that ensures that APS dividend yields reflect the current requirements of investors. Auction market preferred stocks have interest rates or dividends that are periodically reset through Dutch auctions. Interest rate auctions for auction rate securities however began to fall during the 2008 financial crisis. The auctions attracted too few bidders to establish a clearing rate and these dislocations resulted in high or penalty interest rates on those securities and or an ability of investors to sell their auction rate securities. The auction rate securities market collapsed in February 2008 when lead underwriters chose not to step in to support the auctions. For investors this meant that they were left with illiquid investments. Since the collapse of the auction rate securities market, the U.S. Securities and Exchange Commission Financial Investment Regulatory Authority and state attorneys general have reached settlements with major broker dealers and with entities these settlements included agreements to buy back auction rate securities from certain investors.