What is Preferred Stock and How Does it Work?
Preferred stock is a type of share that companies sell to raise money. It’s different from regular stock because the people who own it get a few special perks. For example, they’re usually the first to get paid dividends, which are a kind of payout. These dividends tend to be steady and predictable. Think of preferred stock as a mix of regular stock and bonds.
Preferred stock isn’t the same as common stock. For starters, if you own preferred shares, you don’t usually get a vote in company decisions. However, you do get paid dividends before people who own common shares. If the company runs into trouble, you’ll also be one of the first in line to get paid back.
Companies sell preferred stock because it’s a way to get money without giving up control. Investors like it because they get reliable payouts, but the company doesn’t have to worry about giving them a say in how things are run.
How It Works
Dividend Payments
Preferred stockholders get paid first, before common stockholders, and these payments are fixed. So, if you own preferred shares, you know how much you’re getting regularly.
Voting Rights and Their Absence
Owning preferred stock means you don’t get a vote on company matters. That’s why companies like selling it—it brings in money without letting investors influence decisions.
Priority in Liquidation
If a company goes under, preferred shareholders get their money back before those who own common stock. But they’re still behind bondholders when it comes to who gets paid first.
The Key Features of Preferred Stock
Dividends
One of the biggest reasons people buy preferred stock is for the steady, fixed dividends. These payments don’t change, so it’s a pretty safe way to earn income compared to common stock, where dividends can go up or down.
Some preferred stocks are cumulative, meaning if the company misses a payment, it still owes you and has to make it up later. Non-cumulative preferred stock doesn’t work that way—if they skip a payment, you don’t get it back.
Preferred stock usually pays higher dividends than common stock, but the trade-off is that you don’t get the chance to cash in on big stock price gains like you might with common shares.
Callability
Some preferred stocks are callable, which means the company can buy them back from you at a set price after a certain amount of time. It’s a way for companies to get rid of their dividend obligation if they don’t need the extra money anymore or if they want to lower their costs. Companies might call their stock when interest rates go down. It saves them money because they can issue new stock with lower dividends.
Convertibility
Some preferred stocks can be converted into common stock, usually at a set rate. This can be a good option if the company’s common stock starts doing really well, and you want to switch to potentially earn more from stock price increases.
You can choose to convert your preferred shares into common ones, especially if the company’s stock price is climbing. That way, you could benefit from any rise in the common stock price.
Most people choose to convert their preferred stock when the company is doing well, and they think they’ll make more money by holding common stock instead of sticking with the fixed dividend.
The Different Types of Preferred Stock
Callable Preferred Stock
Callable preferred stock allows the company to buy back the shares from investors after a certain date. This buyback happens at a predetermined price, often a little higher than the original purchase price. Essentially, the company can “call” the stock back whenever they want to, once the conditions are met.
For investors, the benefit of callable stock is that it typically offers higher dividend rates compared to non-callable stock. The downside is that if the company decides to call the stock back, you lose those dividend payments, and you might not find another investment offering the same return. So, while the higher dividends are attractive, there’s a risk that they won’t last as long as you’d like.
Convertible Preferred Stock
Convertible preferred stock allows investors to swap their preferred shares for a set number of common shares. This conversion is usually offered at a pre-determined ratio, meaning you’ll get a specific number of common shares for each preferred share you hold.
The best time to convert is when the common stock is doing well. If the market price of the common shares rises above the conversion price, it can be a great deal for preferred stockholders. You’re essentially trading in a stable but limited income stream for the chance to earn more from the rising value of common shares.
Adjustable-rate Preferred Stock
Unlike most preferred stock with fixed dividends, adjustable-rate preferred stock (ARPS) has a dividend that can change. The dividend rate is usually tied to a specific benchmark, like interest rates or inflation. So, when those benchmarks change, your dividend could go up or down.
When interest rates go up, the dividend on adjustable-rate preferred stock may increase as well, offering you a higher income. On the flip side, when interest rates fall, your dividend could drop. This kind of stock offers more flexibility but also more unpredictability in terms of what you’ll earn over time.
Participating Preferred Stock
Participating preferred stock gives you an extra benefit: if the company does exceptionally well, you might get additional dividends beyond the fixed ones you normally receive. This is a nice bonus for investors who want steady income with the potential for more.
This type of preferred stock is most beneficial when the company is thriving. If the company’s profits exceed a certain level, you get extra dividends, which can significantly boost your returns. However, if the company underperforms, you’ll only receive the regular fixed dividend, which still offers stability.
The Advantages of Preferred Stock for Investors
Reliable Dividend Payments
One of the most appealing aspects of preferred stock is its ability to provide consistent and reliable income through dividends. Unlike common stock, where dividends can fluctuate based on the company’s performance or be skipped altogether, preferred stock dividends are generally fixed. This means, as an investor, you can count on receiving regular payments, which can be especially attractive if you need a dependable income stream.
Attractive to Income-Seeking Investors
Preferred stock tends to draw in investors who prioritize regular income over high-risk, high-reward scenarios. Think of retirees, or individuals saving for a big purchase, who prefer knowing exactly what they’ll earn each period. For these income-seeking investors, preferred stock offers the kind of peace of mind that common stock often doesn’t. There’s less worry about market volatility or a bad quarter reducing or eliminating dividends.
Higher Claim on Assets and Earnings
In the corporate world, not all shareholders are treated equally, especially when things go wrong. Preferred stockholders have an advantage over common stockholders because they have a higher claim on the company’s assets and earnings. This means if the company goes through tough financial times, or even faces bankruptcy, preferred shareholders are paid out before those holding common stock. While it’s not a guarantee you’ll get all your money back, the chances are higher than for common shareholders.
Safety in Case of Bankruptcy
During bankruptcy or liquidation, preferred stockholders sit in a better position than common stockholders, but behind bondholders. If a company is forced to sell off its assets, bondholders are paid first, but preferred shareholders get their money before those holding common stock. This makes preferred stock a bit safer in turbulent times because it offers some protection from total loss, even if the company fails.
Tax Benefits of Preferred Stock Dividends
Another advantage of preferred stock is the potential tax benefits. In some cases, dividends from preferred stock are treated more favorably by tax laws compared to other forms of income, like bond interest. Depending on the jurisdiction, preferred dividends may be taxed at a lower rate than ordinary income, making them a smart choice for investors looking to keep more of what they earn. This tax advantage adds an extra layer of appeal, especially for those in higher tax brackets.
The Disadvantages of Preferred Stock
Fixed Dividends, Lower Potential for Growth
While preferred stock does provide steady dividends, one of the biggest downsides is the limited potential for capital growth. Unlike common stock, where shareholders benefit if the company’s stock price rises significantly, preferred shareholders are typically stuck with their fixed dividends. Even if the company’s profits skyrocket and the common stock price soars, preferred shareholders won’t see any extra financial gain beyond their agreed-upon dividend payments. So, while you enjoy stability, you may miss out on big gains.
Comparison with the Growth Potential of Common Stock
If you’re an investor looking for long-term capital appreciation, preferred stock might not be the best option. Common stockholders can potentially see significant gains if the company performs well, as the value of their shares rises with the company’s success. On the flip side, preferred stock is more like a fixed-income investment, similar to bonds. While the fixed dividend is nice, it means you won’t share in the company’s growth beyond that. So, if you want a piece of the potential growth pie, common stock might offer better opportunities.
Absence of Influence on Company Decisions
For investors who enjoy having a say in how a company is run, preferred stock comes with a downside: no voting rights. This means preferred shareholders have no influence over key decisions like electing the board of directors or approving mergers. Essentially, you’re a silent partner who collects dividends but doesn’t get a vote on the direction of the business. For some investors, this lack of involvement can be frustrating, especially if the company is going through major changes or if its leadership is making controversial decisions.
Interest Rate Sensitivity
Preferred stock can be quite sensitive to changes in interest rates. When interest rates go up, the value of preferred stock tends to go down. This happens because newer preferred stock might offer higher dividend yields, making older issues with lower yields less attractive to investors. In a rising interest rate environment, your preferred shares could lose value, even though the dividend payments stay the same. This risk is similar to what happens with bonds when interest rates rise: investors want newer bonds with higher returns, making existing ones less appealing.
Limited Flexibility Compared to Bonds
While preferred stock can feel like a bond in many ways, it doesn’t always have the same flexibility. Bonds generally have set maturities, so you know when you’ll get your investment back. Preferred stock, on the other hand, often doesn’t have a set end date, meaning your money could be tied up longer. Additionally, since preferred stock is often callable (meaning the company can buy it back from you), you could find your investment being cut short if the company decides to call the stock, leaving you to find new investment opportunities.
Preferred Stock vs. Common Stock: Key Differences
Voting Rights
One of the biggest differences between preferred and common stock is voting rights. Common stockholders get to vote on important company matters, while preferred stockholders usually don’t. This can be a dealbreaker for those who want a say in the company’s direction.
Dividend Payments
Preferred stockholders enjoy more predictable dividend payments, often at higher rates than common stockholders. However, common stockholders might get larger dividends during profitable times since their payouts can fluctuate with company performance.
Risk and Reward Profile
Preferred stock offers less risk than common stock because of its fixed dividends and priority in payouts during liquidation. However, common stock offers greater potential for growth and higher returns, especially when the company is performing well.
Which is Better for Investors?
Preferred stock is better for investors who want steady income without much risk. It’s ideal for those who don’t mind giving up voting rights in exchange for predictable dividends. Common stock is better suited for investors willing to take more risk in hopes of higher returns and who want a say in company decisions.
Real-World Examples of Companies Using Preferred Stock
Large companies like banks and utility firms often issue preferred stock. For example, Wells Fargo and Bank of America have issued preferred shares to raise funds. These companies use preferred stock as a way to attract income-seeking investors without diluting their voting power.
Issuing preferred stock allows companies to raise capital while maintaining control. Since preferred shareholders don’t have voting rights, companies can access funds without worrying about shareholder influence over decisions. Plus, preferred stock tends to attract investors looking for reliable income, which can help stabilize the company’s financial base.
During financial downturns, preferred stock tends to perform better than common stock. For example, during the 2008 financial crisis, preferred stockholders in major banks continued receiving their dividends, while common shareholders saw their stock value plummet. This stability during tough times is why preferred stock remains a popular choice for more conservative investors.
How to Invest in Preferred Stock
Direct Purchase Through Stock Exchanges
You can buy preferred stock directly through most major stock exchanges, just like common stock. The process is straightforward, and you can hold the shares in your regular brokerage account.
Preferred Stock ETFs
Another way to invest in preferred stock is through exchange-traded funds (ETFs) that focus on preferred shares. This option lets you spread your investment across multiple companies, reducing risk and adding diversity to your portfolio.
Risks to Consider
Preferred stock is sensitive to changes in interest rates. When interest rates rise, the value of preferred shares usually falls. This is because new preferred stock with higher dividend rates becomes more attractive, making older shares less valuable.
Just like with common stock, investing in preferred shares carries the risk that the company may not perform well. If the company faces financial trouble, preferred shareholders could still lose money, although they do have priority over common stockholders during liquidation.
Summing Up: Is Preferred Stock Right for You?
Preferred stock offers reliable income, priority over common stockholders in payouts, and less risk. However, it also has less growth potential and no voting rights. If you’re looking for stability, preferred stock could be a good fit. Investors who want a steady income stream, with less concern for stock price growth or having a say in the company, will find preferred stock a great option. It’s perfect for conservative investors or those nearing retirement who value consistent dividends over high-risk growth.
FAQs
Can Preferred Stock Dividends Be Reduced or Stopped?
Preferred stock dividends are generally fixed, but they can be reduced or stopped if the company runs into financial trouble. However, with cumulative preferred stock, any missed dividends are still owed to you and must be paid before common stockholders receive any dividends.
How Long Should You Hold Preferred Stock?
There’s no set time to hold preferred stock—it depends on your financial goals. Some investors hold it for the steady income from dividends, while others may sell if interest rates rise or better investment opportunities arise. However, holding for the long term is common due to the fixed dividend payments.
What Happens to Preferred Stock if a Company Gets Bought Out?
If a company is acquired, preferred stockholders may get bought out at a set price, or their shares may be converted into the preferred stock of the new company. The exact outcome depends on the terms of the acquisition and the rights outlined in the preferred stock agreement.
Is Preferred Stock Considered a Safer Investment Than Bonds?
Preferred stock is riskier than bonds because it doesn’t guarantee repayment like bonds do. However, it is still safer than common stock since preferred shareholders get paid first in the event of liquidation. Bonds, however, are typically the most secure because bondholders get priority over all shareholders.
Can I Lose Money Investing in Preferred Stock?
Yes, while preferred stock offers stability, it’s still possible to lose money. The value of your preferred shares can drop if interest rates rise, and if the company fails, you may not recover your full investment. Preferred stockholders are paid after bondholders in bankruptcy, so there’s still risk involved.
