Auction Rate Bond - ARB

Find it a la shma What is adjustable rate preferred

stock Okay let's start with the basics preferred stock and

yes we have a whole video on this one as

well Preferred stock generally pays a dividend and is often

convertible into common stock at a premium to where it

was issued So preferred stock is kind of bond like

and kind of equity Like fish Most preferred stocks get

issued some set dividend like a base rate of say

six percent or something like that And note that it's

called a dividend in the case of preferred stock not

an interest payment subtle but very important difference here because

interest on bonds is tax as ordinary income and dividends

on equities are qualified meaning that their tax at long

term gains rates or dividend tax rates anyway these preferred

pay six percent no matter what the price at which

one preferred unit trades will fluctuate like a stock or

bond But that thousand dollars par preferred will just continue

to pay its sixty bucks a year in dividends until

the preferred shares are bought back by the company you

know at some premium or until the shares convert into

being common stock or the company goes bankrupt in armageddon

scenario one starring ben affleck jr But in the case

of adjustable rate preferreds it's not always the six percent

that gets paid or whatever the initially stated rate wass

in the case of these equities and yes preferred stocks

considered equity even though it acts like a bond Sometimes

in this case the dividends will very with some set

indexed like t bills or live or where the preferred

dividend might be set on a say a trailing four

quarter bases to be two hundred basis points Mohr interest

that it pays than the average t bill reign as

of blah blah blah blah time frame Well why would

you want this adjustable feature with preferreds Well you can

imagine a scenario in a low interest rate environment where

we have preferred stocks paying five percent and the prevailing

rates are three percent for very high quality dead teo

top notch blue chip companies But then we get inflation

and that three percent for the best borrowers goes to

six percent and a given preferred stock would then need

to pay more like eight percent to be trading around

The thousand dollars par value it was issued at So

said another way if that piece of paper is on

ly giving investors fifty bucks a year when a very

similar piece of paper gives investors eighty bucks a year

investors will want charity They will sell down than thousand

dollar piece of paper giving only fifty bucks to price

low And so that when it's bought it pays eighty

bucks a year in charity right that thousand dollars going

to sell down to nine hundred eight hundred seven hundred

until whatever you pay for it pay the same interest

rate is that eighty dollars year thing Thank you Inflation

specifically In this case a thousand dollars preferred paying fifty

bucks a year would have to sell for six hundred

twenty five bucks teo yield eight percent meaning that the

thousand dollars par value that investors bought in a five

to ten years ago would drop dramatically by three hundred

seventy five dollars a unit to be six hundred twenty

five dollars To be quote at market unquote and that's

a problem a big risk that investors will hate Hence

the invention of the adjustable feature here Adjustable rate preferred

Stock Great inventions So in this case if it preferred

was adjustable if rates went up a cz were describing

here then it is extremely likely that the t bill

or live or rates would go up similarly as they

generally follow inflation grids over time And in this scenario

if the rate of the dividend on the preferred stock

at just's then it's always going to be something like

t bill ray plus three hundred basis points or something

like that so that if there really is big inflation

and federal funds rates go from three percent to six

percent The return on these preferreds would go up about

the same amount making the security much more appealing to

investors Got all that well let's Just hope that if

anything else is in need of getting adjusted those investors

will take care of it in private nia do that