There are a number of differences between stocks and bonds. In addition to those I discussed earlier, the two also differ in terms of the unpleasant things that can go wrong with them. The deal struck between Citigroup and the Treasury recently provides an opportunity to illustrate a few more differences.
In recent months, bank stocks have been tanking even more than the rest of the stock market. Owners of bank stocks have been worried about the naughty assets that may be lurking on their books, for one thing. For another, the possibility that the government might take a larger ownership stake has had owners of common stock worried about something called dilution.
In order to understand stock dilution, remember that a company’s stock represents ownership in it. In our earlier fictional company, TidyPooch (ticker: WOOF), there were 1,000,000 shares of stock; each share represents ownership of one one-millionth of WOOF. Companies can issue new stock in order to raise money. If TidyPooch issues one million additional shares and sells them all, the owners of the original shares suddenly own half as much of the company as they did before. This doesn’t necessarily mean that the shares must drop 50% in value (in selling new stock, the company gained additional capital) but the original shareholders do have their ownership stake reduced. That’s dilution, and it’s easy to understand where the name comes from.
In the case of Citigroup, the company is essentially forcing the conversion of a class of stock called “preferred shares” into new common stock. At present, the federal government owns 7-8% of Citibank through preferred shares (more on those in a moment). The deal involves converting a chunk of the US government’s preferred shares into common stock. At the same time, Citigroup is pressing other preferred shareholders to convert their shares as well. In this case, no additional money changes hands, but the change in stock makeup improves Citigroup’s strength rating as a bank because banking rules treat preferred shares as debt rather than as equity. The conversion also saves Citigroup money, because it no longer has to pay out some of the preferred dividends.
Preferred shares are a special category of company stock that carry a specified dividend. The shares are “preferred” because the company must give preference to them in paying dividends: if the company has to choose between paying dividends to preferred versus common stock, the preferred stock dividend gets priority. Preferred shareholders also have priority over common stock holders (but not bondholders) in dividing up what’s left if the company goes bankrupt.
Currently, in addition to the Citigroup preferred shares in the hands of the US government and the general public, a large amount of its preferred stock is held by the Singaporean sovereign wealth fund and by Saudi Arabian Prince Alwaleed Bin Talal. In order to make sure that all the non-US government shares get converted to common stock, Citibank has suspended all of its dividends on existing shares – the preferred stock holders lose out if they don’t agree to convert. The governments and Prince Alwaleed will receive better conversion terms than Joe Investor. Assuming everyone goes along, the US government’s share of Citigroup ownership will increase from 7% to about 35% – the conversion from preferred to common leaves preferred holders with more ownership, partly compensating them for the loss of dividends. Current owners of Citigroup common stock will see their share of ownership diluted by 76%. Ouch.
What can we learn?
There are a few investing lessons here. Investors in any security should understand what can go wrong with an investment – that’s part of the risk you should be prepared for. In this instance, some preferred stockholders will no longer receive dividends. That’s normally a remote possibility, but Citigroup found it necessary to take a stick to its preferred holders, and it did. As the WSJ has already noted, some preferred stock holders are more “preferred” than others – the small fry preferred holders received less favorable conversion terms and have little recourse. Common stock investors always face a potential risk of dilution, and in this instance Citigroup common stockholders got hosed.
In good times, a potential downside of bonds versus stocks is that if a company grows, the bondholder gets nothing extra, just the regular bond payment, while a stockholder is likely to see the stock value increase. In bad times, the bondholder is ahead of the stockholder in the line for company assets. To preserve the bondholder’s priority, this kind of reorganization is supposed to hurt the stockholders more than the bondholders.
That’s true here: common stock holders got thrashed, preferred stockholders took some licks, and bondholders are left in the best shape as Citigroup’s risk of default should be reduced by the restructuring. The financial company is not out of the woods, though, and bondholders would still get stung if the company has to default on the terms of any its debt.