Preferred Redeemable Increased Dividend Equity Security

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21 Aug, 2024

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A Preferred Redeemable Increased Dividend Equity Security (PRIDES) is a synthetic form of mandatory convertible securities comprising a forward contract and an interest-bearing deposit. It offers holders an opportunity to earn capital gains on maturity. Holders can also enjoy a stable cash flow through interest on deposits.

Preferred Redeemable Increased Dividend Equity Security

Upon maturity, the forward contract is converted into the underlying security, with holders receiving the company’s common stocks. When this happens, interest payments stop, and dividends begin. PRIDES were introduced by Merrill Lynch & Co. These stocks simulate the underlying assets, i.e., the compulsorily convertible securities, but they differ in structure and characteristics.

What Is Preferred Redeemable Increased Dividend Equity Security (PRIDES)?

A Preferred Redeemable Increased Dividend Equity Security (PRIDES) is a synthetic type of stock replicating mandatory convertible security.
It includes a forward contract whereby the holder agrees to buy the underlying security (redeemable preferred stock) and the interest-bearing deposit on the specified date at the decided price.
Such financial instruments allow holders to earn dividends on underlying securities and stable cash flows or interest on their deposits. Moreover, holders can even enjoy capital gains on redemption of their common securities after conversion.

Preferred Redeemable Increased Dividend Equity Security Explained

Preferred Redeemable Increased Dividend Equity Security (PRIDES) mimics the mandatory convertible securities whereby the preferred shares must be converted into common stocks by a specific date. Thus, PRIDES are hybrid securities, combining features of debt and equity instruments. Nevertheless, these investment vehicles are structurally different from convertible stocks; they provide equivalent or superior benefits to investors.

Whenever a publicly traded company issues stock to fund its projects or operations, its outstanding stock prices are affected. Hence, the companies choose convertible securities to mitigate the potential adverse effects on the price of existing shares when raising capital. By allowing conversion later, these securities strike a balance between capital infusion and minimizing immediate dilution. Moreover, the issuing company’s size does not matter when issuing PRIDES.

PRIDES and mandatory convertible securities share the common characteristic of preferred share conversion into common stock, but their structures differ. Convertible securities address the need for capital raising without unduly impacting the price of current shares. PRIDES employ a hybrid structure, and being mandatory convertible securities, the holders finally get common stocks.

Features

Preferred Redeemable Increased Dividend Equity Security (PRIDES) is an advanced investment vehicle. Some prominent traits of PRIDES have been discussed below.

Synthetic Security with Hybrid Characteristics: PRIDES are synthetic forms of securities that simulate convertible preferred stocks, which have traits of both debt and equity.
Redeemable Preferred Stocks: Such securities are based upon the redeemable preference shares, which are given more priority than the common stocks at the time of liquidation or bankruptcy.
Compulsory Conversion to Common Stocks: The underlying security has to be compulsorily converted into common equity on maturity.
Interest Income: The holders of PRIDES receive periodic, regular, and stable returns in interest.
Capital Gain: Holders earn capital gains on the underlying securities.
Appreciation Limit: Unlike common equity, there is an appreciation cap on PRIDES.
Tax Advantage: Most of these securities benefit the holders due to their mandatory conversion into common shares.
No Voting Rights: Unlike common stockholders, PRIDES holders do not have any voting rights in the company.

Examples

Let us study some examples of Preferred Redeemable Increased Dividend Equity Security (PRIDES) in this section to learn more about their features.

Example #1

Suppose a company, StarGold Corp., issues PRIDES that simulate the ABC mandatory convertibles paying an 8% dividend yield and an interest of 5% on a deposit of $10 per stock. A buyer, Stella, enters into a forward contract with the company and agrees to buy the underlying common stocks after one year at $11 per stock.

If Stella buys 100 units, she receives a dividend of 8%, i.e., $80, and an additional interest of $50 on the investment per the contract terms. Also, Stella receives a $1100 capital gain if she redeems the security on the mandatory redemption date.

In another case, if Stella fails to exercise the contract on the mandatory redemption date, say, if she redeems the security before the given date, she may only get the issue price, i.e., $1000, and the due dividend worth $80. Also, she may be charged for early redemption by the company.

This shows how these financial instruments work.

Example #2

Suppose LightKey Co. Ltd. plans to raise capital for a project. The company issued PRIDES in the following manner to meet its funding requirements.

PRIDES issued by the company offered a fixed dividend of 6% per annum to investors.
After 5 years, the dividend rate on these PRIDES increased to 10% per annum. Hence, investors were keen to redeem their PRIDES.

Now, investors can hold these PRIDES and continue receiving the higher dividend or redeem them for a specific amount of common stock per the market price of the company's common stock at this time.

We can see that if investors are risk-averse, they may prefer to receive a fixed dividend instead of converting to common stock at this stage.

Benefits

As we have already seen that PRIDES are a synthetic form of security, they offer numerous advantages. They have been discussed below.

Multi-Income Benefit: PRIDES provide multiple forms of income to the holders. It offers stock dividends and interest on deposits throughout the holding period while allowing the holder to book capital gain by selling the common stocks after conversion.
Tax Advantage: These securities replicate mandatory convertible stocks, mostly subject to tax benefits. However, it is advisable to book a consultation with a tax expert to understand the tax implications.
Stable Cash Flow: The regular and consistent interest payments on the deposits provide PRIDES holders with stable cash flows.
Higher Dividend Yield: These stocks typically offer a higher dividend compared to common equity.
Preferential Treatment: PRIDES holders are paid off before the common stockholders at the time of the company’s liquidation or bankruptcy.

Frequently Asked Questions (FAQs)

Can Preferred Redeemable Increased Dividend Equity Security (PRIDES) be voluntarily redeemed by the investor prior to the mandatory redemption date?

Typically, early redemption is not allowed. However, an investor can redeem it before the mandatory redemption date at the issue price of the security plus any due dividends under certain circumstances. In such cases, the company may levy some early redemption charges.

How is the value of Preferred Redeemable Increased Dividend Equity Security (PRIDES) determined at the end of the agreement?

Its value is ascertained based on a predetermined price as agreed upon during the agreement. The forward contract ends on the date of the mandatory redemption date.

What is the difference between Preferred Redeemable Increased Dividend Equity Security (PRIDES) and a Mandatory Convertible Bond (MCB)?

PRIDES are synthetic assets imitating mandatory convertible securities (usually redeemable preference shares). While they offer similar benefits to that of their underlying securities, their structure and features vary from the latter. Mandatory Convertible Bonds (MCBs) are securities that must be compulsorily converted to the underlying common stock on a specific date.