Table of contents
Introduction
How long have you been wondering about starting investments? Or maybe you’ve already started? It could be a travel fund, or saving up to buy a phone or a car. According to your financial goals, your investment plans and decisions may vary. Lucky for you, there are multiple investment options for you to choose from. There are equity, securities, bonds, gold, REITs and a lot more options that you can select to create a diversified portfolio.
Today we introduce you to an investment option in equity called Preferred Stocks, aka Preference Shares. When companies get dividends, the preference shareholders are the first ones to get their dividends for both, fixed and adjustable preferred stocks. They’re a type of equity investment that gives you a higher claim on earnings and assets than common stocks.
Within the concept of preferred stocks, we’re going to learn about one of the types of preferred stocks – the Adjustable-Rate Preferred Stock (ARPS). It’s a financial instrument that adjusts its dividends based on a benchmark rate. Sounds interesting, right?
So, if you are ready to use a new instrument to diversify your portfolio and learn all the important things about it, strap in and let’s get started.
What is adjustable-rate preferred stock (ARPS)?
Adjustable-Rate Preferred Stock, often abbreviated as ARPS, is a unique type of preference share. What sets it apart? Well, it’s all in the name – “adjustable-rate”. Unlike other types of preferred shares, like fixed shares, the dividends of ARPS are not fixed. Instead, they adjust over time based on a benchmark rate, typically a Treasury bill rate.
A treasury bill is a short-term money-borrowing tool that the Government of India issues. It is a promissory note with a guaranteed repayment later. These bills are issued to reduce the overall fiscal deficit of the country.
The treasury bill rates are released by the Reserve Bank of India and as of April 12th, 2024, the treasury bill rate of the last 91 days stands at 6.87%. These bill rates are used to determine the Adjustable rate of the preferred stocks
So, in a nutshell, ARPS is a type of preferred stock that offers a potential hedge against interest rate risk, making it a unique and valuable tool for certain investment strategies. But remember, like all investments, ARPS comes with its own set of risks and rewards, which we will learn as we go ahead.
How does adjustable rate preferred stock works?
You probably want to know by now – How does this Adjustable-Rate Preferred Stock (ARPS) actually work?
First off, there’s something called a dividend reset date. This is a specific date when the dividends of ARPS are adjusted. It’s kind of like a ‘reset’ button for the dividend rate.
Now, the adjustment of dividends isn’t random. It’s based on the performance of an underlying benchmark. Think of this benchmark as a reference point that helps determine the new dividend rate.
Here’s where it gets interesting. If the benchmark rate changes, it directly impacts the dividend rate. So, if the benchmark rate goes up, the dividend rate follows suit. And if it goes down, well, you guessed it, the dividend rate decreases too.
And that is how ARPS works. It’s a dynamic process that adjusts to market conditions, making ARPS a unique and intriguing financial instrument.
Things to note about ARPS
Adjustable-Rate Preferred Stock (ARPS) comes with unique features and potential risks and benefits.
- One key feature is its preference over equity – ARPS holders get their dividends before regular stockholders. Plus, unlike fixed-rate preferred stocks, the market value of ARPS remains relatively stable. ARPS also has a collared dividend movement, meaning the dividend yields have a floor and cap.
- Collared Dividend Movement refers to the upper and lower limits, or “collars”, set on the dividend yields of Adjustable-Rate Preferred Stock (ARPS). The “floor” is the minimum yield that the ARPS can offer, regardless of how low the benchmark rate might fall. Conversely, the “cap” is the maximum yield, irrespective of how high the benchmark rate might rise. This mechanism ensures a certain level of predictability in the otherwise fluctuating dividends of ARPS.
- However, there’s a risk that dividend payments may decrease if interest rates fall. So, while ARPS can be a rewarding investment, it’s important to consider these factors before diving in.
Conclusion
Adjustable-Rate Preferred Stock (ARPS) offers a unique blend of potential for higher returns and stability, making it a noteworthy consideration for diversifying investment portfolios. However, like all investments, it’s essential to understand its workings and associated risks before diving in.
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FAQs
Companies issue Adjustable Rate Preferred Stocks intending to attract investors who are seeking stable income and capital preservation. ARPS offers dividends that are adjusted with the market rates.
Higher Claim on Distributions: ARPS holders have a higher claim on distributions than common stockholders.
Consistent Dividend Payouts: ARPS provides consistent dividend payouts, making it appealing to conservative investors.
Interest Rate Impact: The adjusted ARPS dividend rate falls when benchmark interest rates decrease, leading to smaller dividends but stable stock prices.
Yes, preferred stocks generally pay a predetermined dividend. Specifically, Adjustable Rate Preferred Stock (ARPS) pays a dividend that adjusts based on changes in a benchmark rate. This means the dividend can increase or decrease over time depending on the benchmark rate.
Yes, the prices of preferred stocks often decrease when interest rates rise. This is because preferred stocks are a type of fixed-income security, and like bonds, they are sensitive to changes in interest rates.
When the benchmark interest rate drops significantly, the dividend paid to holders of Adjustable Rate Preferred Stock (ARPS) also decreases. This is because the dividend of ARPS is tied to a benchmark rate, often a Treasury bill rate. However, the price of ARPS does not change much with the drop in interest rates. The reason for this stability in ARPS prices is the built-in rate adjustments that make the market value less dependent on changes in interest rates.