We're using cookies, but you can turn them off in your browser settings. Otherwise, you are agreeing to our use of cookies. Learn more in our Privacy Policy

Bridge over ocean
1 September 1996 Financial Analysts Journal Volume 52, Issue 5

Estimating the Credit-Risk Yield Premium for Preferred Stock

  1. Leland E. Crabbe

The credit risk of preferred stock is not simply the probability of default. Because preferred stock is legally an equity security, issuers may omit dividends without triggering default or bankruptcy. Historical data suggest that about 6.1 percent of a-rated preferred issuers pass on dividends or default over a 10-year period. For corporate bonds, by contrast, the 10-year default rate for A-rated issuers is about 2 percent. Using a risk-neutral pricing model, this paper shows that the yield spread between corporate bonds and preferred stock depends on the probability of receiving scheduled cash flows and on the price of the security in the event of a default or omission. In practical terms, a-rated preferred stock should trade at a minimum tax-adjusted spread of 26 basis points above A-rated corporate bonds; the minimum spread between b-rated preferred and B-rated bonds should be 517 basis points.

Read the Complete Article in Financial Analysts Journal Financial Analysts Journal CFA Institute Member Content