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A Guide to Preferred
Stock and Related
Securities
Is it a stock or is it a
bond? The answer is
neither. Preferred stocks
are hybrid securities
that combine some of the most attractive features
of both fixed income bonds and equity securities.
While both individual and institutional investors
have participated in the preferred stock market,
the introduction of other forms of preferred stock
and preferred stock-like securities in 1993
prompted an increasing number of individual
investors to become active in this market. This
brochure has been created to familiarize potential
investors with the intricacies of preferred stocks
and other related securities, referred to as $25
debt securities.
Preferred stock can be an important part of a
diversified portfolio; however, investors are
encouraged to thoroughly understand the charac-
teristics of these securities as well as the factors
which may impact their value.
Note: Because of the complexity of certain related
tax issues with regard to the securities described
herein, investors should consider their particular
circumstances and consult with their tax advisor
to determine if an investment in these securities
is appropriate. Current or future proposed legislation
could alter the tax treatment of certain preferred
securities that are described in this brochure.
Some of the more
conventional types of
preferred stock include
fixed-rate, adjustable-
rate, and convertible issues.* However, the
preferred stock market continues to expand as
new structures are developed. Some of these
structures include Monthly Income Preferred
Securities (MIPS
SM
), Quarterly Income Preferred
1
INTRODUCTION
TO PREFERRED
STOCK
TYPES OF
PREFERRED
STOCK
* Convertible preferred stocks are not discussed in
this brochure.
Securities (QUIPS
SM
) and Trust Originated
Preferred Securities (TOPrS
SM
), to name a few.*
1. Fixed rate preferred stockThese securi-
ties carry a fixed dividend rate which is usual-
ly stated in dollar terms or as a percentage of
the preferreds par value. This characteristic
is similar to that of a bond because a set dol-
lar amount will be received by the investor on
the preferred stocks payment date (usually
quarterly). These securities differ from bonds,
however, in that they have no maturity date.
2. Adjustable rate preferred stock
Adjustable rate preferred stocks have divi-
dend rates which are periodically reset based
on a benchmark. These benchmark rates
include the annual market discount rate for
three-month Treasury bills, the 10-year
Constant Maturity Treasury note rate, LIBOR
(which stands for London Interbank Offering
Rate), or some combination thereof. Generally,
the dividends will be subject to minimum and
maximum rate levels over an issues life.
3. Monthly Income Preferred Securities
(MIPS
SM
)These securities, first introduced
in 1993, are typically issued through special
purpose entities which may be structured as a
Limited Life Corporation (LLC), Limited
Partnership (LP), or business trust. The pro-
ceeds raised from the sale of the preferred
shares are loaned to the corporate parent of
the special purpose entity. This loan can also
be made through the purchase of a subordinat-
ed debt security originated by the parent. The
parent corporation is obligated to pay interest
to the special purpose entity, either from inter-
est payments made on the subordinated bond
or from interest paid on the loan. These pay-
ments, usually made on a monthly basis, are in
2
* MIPS and QUIPS are registered servicemarks of Goldman
Sachs; TOPrS is a registered servicemark of Merrill Lynch.
turn passed to the MIPS
SM
holders in the form
of dividends. Interest payments on the loan, or
subordinated debenture, may be deferred for
typically up to 60 consecutive months. If this
occurs, distributions on the preferred securi-
ties will be deferred for the same period.
Because of the issuers right to defer the pay-
ment of interest, the securities are treated for
tax purposes as though they were issued with
original issue discount (OID). Holders of the
preferred securities are required to include
the amount of the income that accrues in any
month as taxable income for income tax pur-
poses, regardless of whether any distributions
are received. (See the Special Risks section
on page 10 for further details.)
In cases where a subordinated debenture is
the basis for the loan, there may be certain
events that occur which could cause a liquida-
tion of the preferred securities and subse-
quent distribution of the subordinated deben-
tures to holders of the preferred securities.
Most features of the subordinated debentures
match those of the preferred securities.
While earlier MIPS
SM
issues have mandatory
redemptions of as long as 100 years, more
recent securities have mandatory redemptions
of 50 years or less. Redemptions will coincide
with the term date of the underlying loan or
subordinated debenture. Where LLC or LP
structures are used to issue securities, holders
are considered partners for federal tax purpos-
es and the accrued income is reported on a
Form K-1, in lieu of reporting on Form 1099.
Keep in mind that distributions made on the
preferred securities will depend on the parent
corporations ability to pay interest on the sub-
ordinated debt security. Therefore, an invest-
ment decision on the preferred security is also
an investment decision on the subordinated
debt security.
3
4. Quarterly Income Preferred Securities
(QUIPS
SM
)The issuing entity of QUIPS
SM
is
structured as a special purpose entity in the
same fashion as MIPS
SM
. The major difference
between MIPS
SM
and QUIPS
SM
is the frequency
of the dividend payment, with the latter paying
dividends on a quarterly basis. Except for the
dividend frequency, features of QUIPS
SM
are
virtually identical to MIPS
SM
. (See preceding
MIPS
SM
section on page 3 for further details.)
There are also some QUIPS
SM
that have been
issued by companies organized as Grantor
Trusts. These QUIPS
SM
share the same charac-
teristics as Trust Originated Preferred
Securities, which are explained below.
5. Trust Originated Preferred Securities
(TOPrS
SM
)Companies that issue TOPrS
SM
are organized as business trusts eligible for
Grantor Trust treatment under the Internal
Revenue Code (IRC), meaning that for federal
income tax purposes, the issuing entity is not
classified as an association taxable as a corpo-
ration or partnership; rather, each TOPrS
SM
holder will be considered an owner of an
undivided interest in a subordinated debt
security. As such, income on the preferred
securities is reported to holders on an accrual
basis on IRS Form 1099- OID.
Like some MIPS
SM
and QUIPS
SM
, when a new
TOPrS
SM
is issued, the proceeds from the sale
are used to purchase a long-term, subordinat-
ed debenture issued by the trusts parent
company, the proceeds from which are loaned
to the parent company. Interest payments on
the subordinated bond are paid to the issuing
trust which, in turn, uses these funds to pay
distributions to the preferred securities hold-
ers. These payments are typically made on a
quarterly basis.
4
Similar to MIPS
SM
and QUIPS
SM
, TOPrS
SM
also
have mandatory redemption dates that corre-
spond to the maturity of the subordinated
debenture. Some issuers of TOPrS
SM
may also
have the option to extend the maturity of the
subordinated debentures for a specified peri-
od of time (e.g., up to an additional 19 years).
If this occurs, the mandatory redemption of
the preferred security is extended by the
same number of years.
Just as with MIPS
SM
and QUIPS
SM
securities,
issuers of TOPrS
SM
may, under the indenture,
defer payments of interest on the subordinat-
ed debt security for a specified period of time
(e.g., 20 consecutive quarters). Should this
occur, distributions on the preferred securi-
ties will be deferred for the same period.
Thus, holders of the TOPrS
SM
are required to
include the amount of income accrued in any
quarter as taxable income for U.S. federal
income tax purposes, regardless of whether
any distributions are received. The accrued
income will be reported annually on IRS
Form 1099-OID. (For further details, see the
Special Risks section on page 10.) There
also may be certain events which could cause
a liquidation of the TOPrS
SM
and a subsequent
distribution of the subordinated debentures
to the holders of the TOPrS
SM
. The subordinated
debentures would have features similar to
those of the TOPrS
SM
.
Distributions on the TOPrS
SM
are dependent
on the subordinated debt issuers ability to
pay interest on such debt. Therefore, an
investment decision on the preferred security
is also a decision with regard to the subordi-
nated debt security.
5
The following are a few
of the most common fea-
tures of preferred stock:
I
Ranking of Preferred StockPreferred
stock is senior to common stock in terms of
capital structure, but junior to all other unse-
cured indebtedness of the issuer, including all
existing and future liabilities of the company.
I
Cumulative dividendsUnlike equity securi-
ties, the dividends of most preferred stocks
are cumulative. This means unpaid dividends
accumulate, and, if in arrears, must be paid
by the issuer prior to fulfilling obligations to
holders of common stock.
I
Intercorporate dividend exclusionSome
preferred stocks qualify for the 70% intercor-
porate dividend received deduction (DRD).
This means that eligible U.S. corporations are
able to exclude 70% of preferred stock divi-
dends from gross income. This exclusion does
not apply to S corporations (Refer to Sections
243 and 246 of the Internal Revenue Code for
eligibility). The DRD can be altered by future
tax law changes. Furthermore, MIPS
SM
,
QUIPS
SM
, and TOPrS
SM
do not qualify for the
70% DRD.
I
Maturity structureMost conventional
preferred stock issues do not have a maturity
date; however, many MIPS
SM
, QUIPS
SM
, and
TOPrS
SM
have mandatory redemption dates.
For details, see the previous section relating
to the types of preferred stock.
I
Redemption provisionsMost preferred
stock issuers retain the right to retire securi-
ties through redemption provisions. Although
the terms differ for each issue, a number of
preferred stocks are redeemable after five to
10 years, in whole or in part, at either par or a
6
FEATURES OF
PREFERRED
STOCK
premium to the original par amount. The pre-
mium, if any, usually declines to par over
a specified period of time.
I
Preference of assetsIn case the issuing
corporation, or special purpose entity, experi-
ences financial failure, preferreds usually
contain provisions that entitle shareholders
to the liquidation preference of the preferred
security before distributions to common
stockholders can be made. This provision is
activated once settlements with creditors and
senior debt holders are met. Keep in mind
that, as previously mentioned, preferred stock
is subordinate to all secured and unsecured
creditors of the issuing entity.
I
Preference of dividendsPreferred stock
dividend payments are considered senior to
the common stock dividend payments. For
instance, if an issue is cumulative, the issuer
cannot pay any dividends to common stock-
holders before obligations to the preferred
holders have been met.
I
MIPS
SM
, QUIPS
SM
, and TOPrS
SM
are exempt
from Non-Resident Alien (NRA) with-
holdingDividends on U.S. preferred stocks
are generally subject to 30% (or lower treaty
rate) withholding for NRA holders. However,
distributions on MIPS
SM
, QUIPS
SM
, and TOPrS
SM
are exempt from U.S. withholding when an
NRA has provided a W-8.
Like most other types
of investment vehicles,
preferred stocks
have certain risks of
which the investor
should be aware.*
7
* This risk summary is not intended to be complete.
Other risks relating to a specific issue may exist and
are disclosed in the securitys prospectus.
RISKS RELATING
TO PREFERRED
STOCK
I
Call provisionsWhen evaluating the pur-
chase of a preferred stock, one should
be aware of any features that may allow the
issuer to call the security. This is particularly
important when considering an issue that is
trading at a premium to its call price because,
if the issue is redeemed, the return may be
negatively impacted.
I
Sinking fundsShould a preferred stock be
subject to a sinking fund, the issuer is typical-
ly required to retire a certain percentage of
the total issue over a specified period of time.
Eventually, much of the preferred stock issue
could be retired in this manner. The primary
difference between a call provision and a
sinking fund is that the issuer calls securities
on a voluntary basis whereas a sinking fund is
usually mandatory and must conform to a set
schedule. Just as with call provisions, one
should be aware of the potential impact to a
preferred stocks return if it is subject to a
sinking fund provision. MIPS
SM
, QUIPS
SM
, and
TOPrS
SM
are not usually subject to sinking
fund provisions.
I
Limited voting rightsGenerally, preferred
stock shareholders do not have voting rights
unless preferred dividends have been in arrears
for a specified number of periods. At that point,
investors may elect some number of directors
to the issuers board. Once all the arrearages
have been paid, however, the preferred stock-
holders no longer have voting rights.
In the case of MIPS
SM
, QUIPS
SM
and TOPrS
SM
,
shareholders have no voting rights, except 1)
if the issuer fails to pay dividends for a speci-
fied period of time (usually a period that is
8
longer than the allowed dividend extension),
or 2) if a declaration of default occurs and is
continuing. In the case of such an event,
rights of holders would generally include the
right to appoint and authorize a trustee to
enforce the companys rights as a creditor
under the agreement with the parent.
I
Special redemptionsThere exist certain
conditions under which a preferred issuer can
redeem shares prior to a specified date. While
these circumstances can vary from issue to
issue, investors should be aware of the events
that can trigger such a redemption. For
instance, in the case of MIPS
SM
, QUIPS
SM
and
TOPrS
SM
, the securities may be redeemed
should a change occur to federal income tax
law or federal securities laws pertaining to
these securities. Occurrences that may trigger
special redemptions can be located in an
issues prospectus.
I
LiquidityMost preferred securities are list-
ed on a major stock exchange (e.g., the New
York Stock Exchange), providing investors
with a degree of liquidity. While PaineWebber
endeavors to make a market for preferred
securities, it is under no obligation to do so.
Accordingly, no assurance can be given as to
the liquidity of, or trading markets for, pre-
ferred securities.
I
Interest rate fluctuationBecause pre-
ferred stocks are interest rate sensitive, the
prevailing rate environment can cause the
market level of an issue to fluctuate. For
example, if interest rates are rising, preferred
stock issues could experience a decline in
market value.
9
I
Credit riskThe creditworthiness of an
issuer will influence both the ability to make
dividend payments as well as the level at
which shares will trade. Even if the issuer is
paying dividends, but is downgraded, the mar-
ket value may be adversely affected. For
instance, if the rating of an issuing corpora-
tions preferred stock is downgraded, or on
watch for a potential downgrade, the shares
can depreciate in price.
With regard to the afore-
mentioned securities, in
most cases, the parent
company may defer pay-
ment of interest on the
subordinated debenture,
or the loan as the case may be, for a specified
period of time (typically up to 60 consecutive
months or 20 consecutive quarters). If this occurs,
dividend payments on the preferred securities will
be deferred for the same time frame and the mar-
ket value of the security is likely to be affected.
For U.S. federal income tax purposes, should an
extended payment period occur, holders would
be required to include the accrued income in
advance of the receipt of cash. Should a holder
dispose of shares prior to the record date for pay-
ment of dividends following such an extended
period, they would not receive the cash related
to the accrued, yet unpaid, income. (A holders tax
basis would be increased for accrued income not
yet received.) Typically, the parent company may
not pay dividends on, redeem, purchase, or
acquire any of its capital stock should such a
deferral occur.
In addition, should the issuer exercise its right to
defer payments on the preferred securities, the
market price and liquidity on the securities would
likely be adversely affected.
10
SPECIAL RISKS
RELATING
TO MIPS
SM
,
QUIPS
SM
,
AND TOPRS
SM
Corporations can issue
different classes of pre-
ferred stock but are
sometimes limited to the
amount of senior pre-
ferred shares they are
allowed to have outstanding. As a result, issuers
may offer different preferred stock classes that
are not subject to the same limitations.
I
Senior preferred sharesThese shares have
claim to assets before preference, or junior,
shares should the issuing corporation be
forced to liquidate. Senior preferred shares
also have first claim to dividends and can
sometimes receive payments when a junior
class does not.
I
Junior preferred shares, or preference
sharesGenerally, preference shares rank
below senior preferred shares, but above com-
mon stocks. There can be several series of
preference shares, each ranking equally with
the other in terms of claims to dividends and
assets. Other rights or restrictions can exist,
usually on an issue by issue basis.
I
Depositary preferred sharesDepositary
shares represent a fractional interest in a
whole share of preferred stock or preference
share. The underlying preferred is deposited
with a custodian and is never traded in the
secondary market. Fractions of the underlying
preferred stock can then be created. The
resulting depositary, or fractional, shares enti-
tle the holder to proportionally the same priv-
ileges as the underlying preferred stock.
In general terms, MIPS
SM
, QUIPS
SM
, and
TOPrS
SM
usually rank equally with (pari
passu) the senior most preferred stock of the
parent company. However, there are some
exceptions. Individual priority rankings are
specified in an issues prospectus.
WHAT ARE
THE DIFFERENT
CLASSES OF
PREFERRED
STOCK?
11
Originally, many pre-
ferred stock buyers were
large institutions which
purchased preferred
stocks to take advantage of their special tax
treatment. However, with the advent of the new
preferred stock structures not eligible for the
intercorporate dividend received deduction, indi-
vidual investors now comprise a large portion of
the preferred market volume. Consider the follow-
ing advantages:
I
Preferred stock offers attractive returns
Because many preferred stock issues trade at
yield premiums versus long-term Treasuries,
investors are able to realize attractive
returns. For eligible corporations, the higher
after-tax yields, due to the 70% intercorporate
dividend received deduction, make owning
preferred stocks particularly beneficial.
Furthermore, MIPS
SM
, QUIPS
SM
, and TOPrS
SM
typically offer additional yield spread versus
other types of preferred stocks. This differ-
ence is partially attributed to the fact that
they do not qualify for the 70% intercorporate
dividend received deduction. Issuers compen-
sate investors for this lack of special tax treat-
ment in the form of additional yield. Since the
intercorporate dividend received deduction
does not apply to individual investors, the
yield premium above Treasury securities can
be especially appealing.
I
Marketability of preferred stockMost
preferred stocks trade on various exchanges,
including the NYSE, AMEX, or over-the-
counter. There can be no assurance, however,
of the development or maintenance of an
active market for the preferred securities on
the exchange.
I
Purchasing powerInvestors are able to
purchase preferred stocks with low par
amounts of $10, $25, $50 or $100.
WHY PURCHASE
PREFERRED
STOCK?
12
Another example of the
changing nature of this
market is the introduc-
tion of $25 par debt securities. While these instru-
ments are technically regarded as subordinated
debt, they have characteristics that are similar to
those of MIPS
SM
, QUIPS
SM
, and TOPrS
SM
. Included
among these debt securities are: Monthly Income
Debt Securities (MIDS
SM
), Quarterly Income Debt
Securities (QUIDS
SM
), and Quarterly Income
Capital Securities (QUICS
SM
).*
Some of their more common characteristics
include:
I
Monthly or quarterly interest payments
As their names indicate, MIDS
SM
pay on a
monthly basis, while QUIDS
SM
and QUICS
SM
pay on a quarterly basis.
I
Deferral of interest paymentsThe issuing
company has the right to defer interest pay-
ments for a certain period of time, as speci-
fied in the prospectus (typically up to 60 con-
secutive months or 20 consecutive quarters),
possibly resulting in an adverse impact on
market value and liquidity (see the risk sec-
tion which follows).
I
Coupons are usually fixed-rate and
cumulativeIn most cases, these securities
have a set interest rate. In the event that
interest payments are deferred, such pay-
ments will accumulate, and must be paid by
the issuer prior to fulfilling obligations to
holders of capital stock. Additionally, some
issuers are required to pay interest on the
accumulated deferred payments, although
this feature does not apply to all issues.
OTHER RELATED
SECURITIES
13
* MIDS and QUIDS are servicemarks of Goldman Sachs;
QUICS is a servicemark of Lehman Brothers.
I
Final maturityThese securities have a
final maturity, usually 30 years, with the
option to redeem the securities, typically after
five to 10 years.
I
Not eligible for the Intercorporate Dividend
Received Deduction (DRD)Because these
securities are interest bearing, subordinated
debentures, they are not eligible for the 70%
dividend received deduction.
I
ListingMost of these debt securities are
listed on a major stock exchange, such as the
New York Stock Exchange. However, there can
be no assurance of the development or main-
tenance of an active market for the debt secu-
rities on the exchange.
I
Priority to assetsBecause these securities
are usually subordinated debt obligations of
the issuer, their claim to the assets of the
issuing corporation, in most cases, is senior to
that of preferred stock holders. However,
these securities rank junior in status to all
other secured or unsecured debt of the issu-
ing corporation.
I
Interest reported on IRS Form 1099
Interest payments from these debt securities
are reported on IRS Form 1099- OID.
I
Exempt from NRA WithholdingJust as
with MIPS
SM
, QUIPS
SM
, and most TOPrS
SM
, dis-
tributions on MIDS
SM
, QUIDS
SM
, and QUICS
SM
are exempt from U.S. withholding when an
NRA has provided a W-8.
14
Investors considering
the purchase of these
debt securities should
be aware of their
specific risks. A few of these risks are summa-
rized below:*
I
Effects of deferral featureFor income tax
purposes, the interest on these issues is
included in the income of the investor as it
accrues, rather than when it is paid. Should
the issuer exercise its option to defer interest
payments for a specific time period, the hold-
er of the security would still be required to
report the annual accrual of interest on the
bond prior to the receipt of the cash. In addi-
tion, an interest deferral may negatively
impact the market value of the debt security.
I
Interest rate riskLike preferred stocks,
these securities are affected by changes in
the level of interest rates. For example, if
interest rates are rising, these securities
could experience a decline in their market
value.
I
Credit riskThe creditworthiness of an
issuer may affect the ability to pay dividends
as well as influence the level at which shares
will trade. Erosion of a companys credit
rating can negatively impact a securitys
market value.
SOME RISKS
RELATING TO
THESE SECURITIES
15
* Other risks may exist similar to those outlined on
pages 7-10 of this brochure. These risks are disclosed in
the securitys prospectus.
PaineWebber is an active
participant in both the
primary and secondary
markets for preferred
stock and related securities. Primary preferred
stocks and $25 par debt securities are sold by
prospectus. Shares in the secondary market trade
either over-the-counter or on a major stock
exchange, like the NYSE.
The evolution of pre-
ferred stocks and related
securities has placed
PaineWebber among the
leading underwriters
and market makers for
these issues. Call your
PaineWebber Financial Advisor and ask for more
information about preferred stock. It could be the
investment you need to accomplish your portfo-
lios objectives.
WHY INVEST IN
PREFERRED
STOCKS AND
RELATED
SECURITIES AT
PAINEWEBBER?
THE PRIMARY VS.
THE SECONDARY
MARKET
16
[\]^@
1999 PaineWebber Incorporated
990422-0640 Member SIPC I165
www. pai newebber. com