Convertible Adjustable Preferred Stock (CAPS): A Flexible Investment Option

Highlights

• CAPS are hybrid securities combining features of both preferred stock and convertible bonds.
• They offer investors the option to convert preferred shares into common stock at a later date.
• CAPS provide adjustable dividend rates, offering flexibility in response to market conditions.

Introduction
Convertible Adjustable Preferred Stock (CAPS) is a specialized type of preferred stock that offers investors flexibility and potential for growth. CAPS are a hybrid investment, combining elements of both preferred stock and convertible bonds, making them attractive to certain investors seeking a balance of income and capital appreciation potential.

The key feature of CAPS is their convertibility—investors have the option to convert their preferred stock into common stock under specified conditions. Additionally, CAPS have an adjustable dividend rate, which is typically tied to an underlying benchmark or index, allowing it to fluctuate over time. This structure gives both the issuer and the investor greater flexibility in managing risks and returns. In this article, we explore the key features of CAPS, how they work, and their potential benefits for both issuers and investors.

Understanding Convertible Adjustable Preferred Stock

CAPS are a relatively unique type of security that combines two primary features: convertibility and adjustable dividends.

1. Convertible Feature: Like other convertible securities, CAPS give the investor the option to convert the preferred shares into a predetermined number of common shares at a specified conversion price. This gives the investor the potential to benefit from capital appreciation if the company's stock price rises significantly. The ability to convert the shares means that CAPS have an equity upside, which distinguishes them from traditional preferred stock.
2. Adjustable Dividend: One of the defining features of CAPS is their adjustable dividend rate. Instead of having a fixed dividend rate, the dividend paid on CAPS can fluctuate based on a specific formula or index, often tied to interest rates or other market benchmarks. This flexibility allows the company to adjust its payout in response to changing economic conditions or corporate profitability, providing an advantage over traditional fixed-rate preferred stock, which may be less adaptable to market changes.
3. Preferred Stock Characteristics: As with other types of preferred stock, CAPS generally provide the investor with priority over common shareholders in receiving dividends and in the event of liquidation. This makes CAPS relatively lower risk compared to common stock, especially for income-focused investors.
   

How CAPS Work: A Detailed Breakdown

CAPS are structured to give both the issuer and the investor flexibility in terms of dividends and potential for growth. Here's how they work:

1. Dividend Payments: The issuer typically pays a dividend on CAPS, but unlike traditional preferred stock, the dividend is not fixed. Instead, the dividend is adjustable, and the rate may be tied to a benchmark, such as the LIBOR (London Interbank Offered Rate), Treasury yields, or other market indicators. This means that the dividend rate can rise or fall depending on the prevailing interest rate environment or other factors, providing a level of protection to investors against inflation or interest rate changes.
2. Conversion Option: The conversion feature allows the investor to convert the CAPS into common stock of the issuing company. The conversion ratio is predetermined, and it specifies how many common shares the investor will receive for each CAPS they hold. This feature provides upside potential if the company’s common stock appreciates in value, as the investor can potentially convert their preferred shares into common stock at a favorable price.
3. Issuer Flexibility: For the issuer, CAPS offer a way to raise capital while maintaining flexibility in dividend payments. Since the dividend rate is adjustable, the issuer can manage its cash flows more effectively in periods of financial stress or fluctuating market conditions. Additionally, the conversion feature allows the company to eventually reduce its dividend burden and potentially convert preferred equity into common equity, which can help strengthen its balance sheet.

Advantages of CAPS

There are several key benefits to CAPS, both for investors and issuers:

1. Investor Advantages:
• Income Potential: Like traditional preferred stock, CAPS provide a steady stream of income through dividends, which is attractive to income-focused investors.
• Upside Potential: The ability to convert CAPS into common stock offers investors the potential for capital gains if the underlying stock price appreciates. This feature provides an opportunity for growth while still enjoying the stability of preferred stock dividends.
• Dividend Flexibility: The adjustable dividend feature allows CAPS to remain competitive in different interest rate environments, offering protection against rising rates.
2. Issuer Advantages:
• Flexible Financing: CAPS offer issuers a flexible method of raising capital, particularly during periods of low interest rates, as the adjustable dividend feature can help manage cash flow.
• Lower Initial Dividend Costs: Since the dividend is adjustable, companies may be able to offer lower initial dividends than they would with fixed-rate preferred stock, which can be beneficial when capital is scarce.
• Equity Conversion: The option for conversion into common stock allows issuers to eventually convert a portion of their debt into equity, potentially improving their debt-to-equity ratio and reducing future dividend obligations.

Risks and Disadvantages of CAPS

While CAPS offer flexibility and a combination of income and growth potential, they are not without risks:

1. Market Risk: Since the dividend rate is adjustable, there is a risk that the dividend could decrease if the market conditions or the benchmark rate declines. This could make CAPS less attractive if income is the primary investment goal.
2. Conversion Risk: The conversion feature introduces equity risk. If the company's stock price does not rise as expected, the option to convert into common shares may not be valuable. Additionally, the conversion could result in the dilution of existing shareholders' equity, which could negatively impact the stock price.
3. Complexity: CAPS are more complex than traditional preferred stock, and investors may need to carefully evaluate the terms of the security, including the conversion ratio, the adjustable dividend formula, and the potential risks involved. This complexity may make CAPS less appealing to certain investors, particularly those who prefer simpler investment vehicles.

Conclusion
Convertible Adjustable Preferred Stock (CAPS) is a hybrid security that offers a unique combination of features found in both preferred stock and convertible bonds. By providing adjustable dividends and the option to convert into common stock, CAPS offer flexibility for both issuers and investors. For investors, CAPS provide a potential income stream with the upside potential of equity conversion, while issuers benefit from more manageable dividend payments and the possibility of strengthening their balance sheets.

However, the adjustable dividend feature and conversion risk can introduce uncertainties, and investors must carefully assess the terms of each CAPS offering to ensure they align with their investment objectives and risk tolerance. For companies, while CAPS provide a flexible way to raise capital, they also come with the potential for equity dilution and a complex structure that may not be suitable for all types of issuers.

Ultimately, CAPS can be an effective financial instrument for both investors seeking income and growth, and issuers looking for a flexible way to raise capital during periods of uncertainty. However, careful consideration of the associated risks and features is essential for success with these hybrid securities.