Preference Equity Redemption Cumulative Stock (PERCS)

What Is Preference Equity Redemption Cumulative Stock?

Preference Equity Redemption Cumulative Stock (PERCS) is an equity derivative that is classified as a hybrid security and automatically converts to equity at its pre-determined maturity date.

Understanding Preference Equity Redemption Cumulative Stock (PERCS)

Preference Equity Redemption Cumulative Stock (PERCS) is a convertible preferred stock with an enhanced dividend that is limited in term and participation. Preference equity redemption cumulative stock shares can be converted for shares of common stock in the underlying company at maturity. If the underlying common shares are trading below the PERCS strike price, they will be exchanged at a rate of 1:1; but if the underlying common shares are trading above the PERCS strike price, common shares are exchanged only up to the value of the strike price.

PERCS = min ⁡ ( Stock Price , PERCS Capped Price ) \begin{aligned} &\text{PERCS} = \min{ (\text{Stock Price}, \text{PERCS Capped Price}) } \\ \end{aligned} PERCS=min(Stock Price,PERCS Capped Price)

PERCS are essentially a form of a covered call option structure and are popular in an environment of declining yields because of the enhanced dividend. Upside profits are limited in order to produce a higher yield. PERCS can typically be redeemed before the maturity date, but at a premium to the cap price. Typically, if a holder of a PERCS does not redeem the shares within the mandated time horizon, usually a three to five year period, the shares are automatically converted to common stock shares and the dividends revert to those ordinary dividends that would be paid on that common stock.

PERCS falls under the umbrella of a non-traditional convertible security known as "mandatory convertibles." These securities have their own unique set of risk and reward characteristics, but they all share similar basic features. These include an upside potential that is typically less than that of the underlying common stock, due to the fact that convertible buyers must pay a premium for the privilege of converting their shares, and higher than market (enhanced) dividend rates.

There are three main characteristics of a mandatory convertible security, and these are true for PERCS as well:

1. Must have a mandatory conversion to the underlying stock.
2. Must have a dividend yield that is higher than that of the underlying stock.
3. Holder is entitled to capital appreciation, but it will be limited when compared to the appreciation potential of the underlying stock.

Other common mandatory convertibles are:

Example of Preference Equity Redemption Cumulative Stock (PERCS)

For example, if you own 10 PERCS on XYZ company with a strike price of $50, at maturity the following two outcomes could happen:

At the same time, say the dividend paid on common shares of XYZ is $1.00 per year. The PERCS shares might pay a dividend of $1.20 per year to their holders.