Guaranteed Stock - Explained
What is Guaranteed Stock?
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Table of ContentsWhat is Guaranteed Stock?How is Guaranteed Stock Used?Academic Research on Guaranteed Stock
What is Guaranteed Stock?
A guaranteed stock is a type of preferred stock which is issued by a corporation and whose dividends are guaranteed by one or more other corporations or banks. In the event of a default by the issuer of guaranteed stock, the guarantor(s) will be obliged to pay dividends to the stockholders. Guaranteed stocks such as guaranteed bonds are most commonly issued by railroad corporations and public utility companies, and usually command a higher market price than non-guaranteed stocks due to the lower levels of risk involved. However, the financial and credit history of the guarantor corporation plays an important role in deciding the final market price of a guaranteed stock.
How is Guaranteed Stock Used?
Guaranteed stock may sometimes be used by companies that are either (1) incapable of paying dividends altogether, or (2) are in the midst of serious financial hurdles that are threatening their ability to continue paying dividends. In scenario (1), the company cannot pay dividends because, in all possibility, it itself is not earning profits.
On the other hand, in scenario (2), the company may be presently capable of paying dividends, but it is undergoing significant financial issues that are an obvious threat to its future profitability such a company, naturally, cannot guarantee dividends in the future. I
n both scenarios, the companies are in no position to guarantee payment of dividends to their investors. As such, by issuing guaranteed stock, these companies rope in third party institutions, mostly banks, as guarantors of dividend payments.
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Guaranteed stock differs from regular preferred stock in that the latter is usually guaranteed even in the event of a bankruptcy. Moreover, preferred stock carries certain privileges for stockholders over common stock these include receiving dividend payments on priority until the whole stipulated sum of dividends has been paid in full. It is only after the preferred shareholders' dividend has been paid in its entirety that common stockholders start receiving their share of the dividends.
In the event of a bankruptcy filing, preferred stockholders receive payments out of the liquidated assets before the common stockholders. However, during such an emergency, the creditors and bondholders of the company supersede even preferred stock investors in receiving payments. Irrespective of the nature of the stock, issuing companies usually make efforts to ensure that dividends are duly paid to investors most ethical businesses are extremely reluctant to cut or halt dividends even for common stock, and refrain from doing so unless it becomes an absolute necessity.
In case of dividends for preferred stock, a company is obliged to make up for any dividend payments that were missed or cut. All preferred stock dividends, including those obtained from guaranteed stock, are taxed differently compared to other assets. Such dividends can be of two distinct types qualified dividends and ordinary dividends. Of the two, qualified dividends typically incur lower taxation than even regular income. In the United States, in order to be qualified, a company must satisfy the following conditions:
- It must incorporate a normal corporate structure.
- It must trade on one of the major U.S. stock exchanges.
- Its shares must be owned by investors for a period that exceeds 60 days of the holding period.
Since most stock issuing companies in the U.S. comply with the above conditions, most regular dividends paid out by corporations there are qualified. Note: The term Guaranteed Stock may sometimes be used interchangeably with Safety Stock. In this regard, guaranteed stock may refer to the additional quantity of an item that a company many choose to hold in its physical inventory in order to maintain a steady supply of such an item.
Safety stocks are buffers that are usually only created for items that sell in high quantities the motive behind such an exercise is to prevent the item from going out of stock when sales are higher than expected or when the manufacturer or supplier is unable to supply additional units at the expected time. There are two types of risks associated with such a strategy: (1) The additional cost involved in carrying and guaranteeing such a large inventory. (2) The risk of a surplus stock that results from the item failing to sell as expected. Surplus stocks usually need to be disposed of at discounted prices, which causes the business to lose money.