Preferred Stock and the Debt-Equity Hybrid Puzzle: An Analysis Using Credit Ratings
This study investigates the effect of preferred stock on the credit ratings assessed by professional credit analysts. Preferred stock inherently contains both features of debt and equity financing. Hence, the nature of preferred stock has presented a puzzle to the efforts of accounting regulators such as the Financial Accounting Standards Board to consistently classify within the existing framework established by financial reporting standards. I find evidence that the association of preferred stock with credit analysts' assessments of credit risk depends on two factors. First, the association of preferred stock with credit ratings varies by the type of preferred stock. Preferred stock that is redeemable is negatively associated with credit ratings, while nonredeemable preferred stock bears no consistent association with credit ratings. Second, the negative association of redeemable preferred stock with credit ratings is sensitive to the firm's financial condition. For those firms in poor financial health, the negative association dissipates. This is in line with preferred stock's inability to drive an insolvent firm into bankruptcy.