DEFINITION of 'Convertible Adjustable Preferred Stock - CAPS'

Convertible adjustable preferred stock (CAPS) is a hybrid form of preferred stock. The dividend payout is set at a base rate plus a benchmark interest rate and resets at specified points in time. Shares are convertible into shares of common stock at a price set when the preferred stock is issued.

BREAKING DOWN 'Convertible Adjustable Preferred Stock - CAPS'

Corporations issue preferred stock as a means of adding equity to their balance sheet or in the belief the cost of capital will be lower than issuing debt. Investors are promised a preferred dividend that must be paid before a corporation is allowed to pay dividends on the common stock. Analysis of any offering should include the corporation's credit rating and the availability of funds to pay the dividend. CAPS are special as they add two features to entice investment in the security.

Convertibility

The convertibility rules are set when the preferred stock is initially issued. A CAPS initially priced at $100 per share might be convertible into four shares of common stock with a basis of $25 per share. If the common price rises to $30, the conversion profit is $20, or 20%. The price of the preferred shares increases to reflect the potential profit. Investors can choose to sell the preferred shares, convert to common shares or keep collecting dividends. Corporations offer convertibility hoping the potential for capital gains allows for a lower dividend payment.

Adjustability

The dividend and how it is adjusted is laid out in the offering documents at the time of issuance. The dividends are a set percentage added to a major benchmark interest rate. The most common benchmarks are the LIBOR, short-term U.S. Treasury bills or U.S. Treasury notes.

A $100 par value CAPS might have a base annual payment of 4% plus the rate of a Treasury note paying 1%, which makes the total payment 5%, or $5. If the Treasury rate rises to 2%, the total payout increases to $6, or 6%.

The adjustment feature stabilizes the market price of CAPS shares, protecting investors from the potential capital loss associated with standard fixed-income securities in a rising interest rate environment. Share values are still susceptible to fluctuation based on changes to the issuing corporation’s credit rating.

Taxation

Shares of preferred offerings are attractive to high-income investors because dividends are taxed at a lower rate than interest income. The top tax rate on interest income is 39.6% on interest income, while dividends are taxed at a top rate of 20%. Investors in lower marginal tax rates also receive substantial tax breaks on dividend income.

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