What is an Adjustable Rate Preferred Stock?

Adjustable Rate Preferred Stock

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Adjustable Rate Preferred Stock

Adjustable-rate preferred stock (ARPS) is a type of preferred stock whose dividend payments are tied to prevailing interest rates or a benchmark rate, such as LIBOR (London Interbank Offered Rate) or the U.S. Treasury rate. This means that the dividend payments on the adjustable-rate preferred stock can increase or decrease as market interest rates change.

The main objective of issuing adjustable-rate preferred stock is to reduce the interest rate risk for the investors. Since the dividend rate is adjusted periodically based on current market conditions, investors in ARPS can benefit from higher dividend payments when interest rates rise and are less exposed to the risk of declining income when rates fall.

Example of an Adjustable Rate Preferred Stock

Let’s consider a hypothetical example to illustrate adjustable-rate preferred stock (ARPS).

Suppose Company XYZ issues 1,000 shares of ARPS with a par value of $100 per share, raising a total of $100,000 in capital. The dividend rate for the ARPS is set at 3% above the 1-year U.S. Treasury rate, and the dividends are paid quarterly.

Initially, the 1-year U.S. Treasury rate is at 2%. This would make the dividend rate on the ARPS 5% (2% + 3%). With a par value of $100, each share of ARPS would pay an annual dividend of $5 ($100 x 5%), or $1.25 per quarter.

Now, imagine that after six months, the 1-year U.S. Treasury rate increases to 3%. The dividend rate on the ARPS would be adjusted to 6% (3% + 3%), resulting in an annual dividend of $6 per share ($100 x 6%), or $1.50 per quarter.

In this example, investors holding the adjustable-rate preferred stock would benefit from an increase in dividend payments as the underlying benchmark rate (the 1-year U.S. Treasury rate) rises. This feature allows ARPS holders to maintain a more stable income stream that adjusts with changing interest rates, providing some protection against inflation and interest rate risk.

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