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Financial Literacy

Preferred Stock: What Is It and How Do I Invest?

A preferred stock is a type of stock that combines certain features of common stock and certain features of debt. Like common stock, preferred stock can increase in value through capital appreciation over time. But, like debt, you can earn interest through fixed payments which helps you boost your income.

Let’s take a deeper look into what preferred stock actually is.

A businessman touches a screen that says "preferred stock"

What Is Preferred Stock?

One of the most important differences between common stock and preferred stock is that shareholders of the latter have a higher claim to dividends or other distributions of assets. That means that before common shareholders receive dividends, preferred shareholders must receive theirs.

Generally, preferred stock tends to yield at a higher rate than common stock. As a result, it can be a helpful tool in increasing your monthly investment income. Companies can pay these higher-yielding dividends on a monthly or quarterly basis.

Preferred stock dividend payments can also be either fixed or pegged to a benchmark interest rate such as the LIBOR. Variable-rate loans can protect you if interest rates increase, but you also face some risk if interest rates decrease.

Whether or not to pay out dividends is up to the discretion of a corporation’s board of directors. But what remains true is that companies must pay dividends to preferred shareholders before common shareholders because the former have a higher dividend claim.

Another difference between common and preferred stock is that holders of the latter have fewer rights. Generally, preferred stock holders do not have voting rights with their shares, however, investors may still prefer them due to the stability or increased yield of their dividend payments.

Orders of Priority

A financially distressed company may need to suspend its regular dividend payments. When this happens, it’s sometimes the case that preferred stockholders must be paid dividends in arrears before any new common stock dividends can be paid. Such preferred stock is called cumulative.

A company can issue new shares of preferred stock at different times when they want to raise funds. When that happens, the stock is often ranked in terms of priority. In this case, higher priority dividends must be paid out before lower priority dividends. The highest priority stock is named Prior, followed by first preference, second preference, and so on.

In the case that a company goes bankrupt and is liquidated, preferred shareholders have a higher claim on assets than common stockholders. However, creditors and bondholders have higher priority still. In general, this makes preferred stocks riskier than bonds but less risky than common stock, all things being equal. Generally, this additional risk leads to higher yields.

Other Features of Preferred Stock

There are some other important features of preferred stocks including:

  • Voting rights
  • Price
  • Callability
  • Convertibility

Let’s look at each of these features in turn.

Voting Rights

In general, preferred shareholders often lack voting rights. However, it is sometimes the case that even those shareholders can receive a vote for their share when regularly scheduled dividends are not paid out. This gives shareholders at least some say in their financial future.

Price

Preferred stock prices have the ability to appreciate more than bonds do, but less than common shares. But they still tend to trade within a few dollars of their par value (usually $25 per share), as do bonds. Things that affect the price of a share include the following:

  • The company’s credit ratings
  • If the shares are cumulative
  • Issue priority
  • Callability

These factors affect whether the stock trades at a premium or a discount to par value.

Callability

Sometimes the issuing company has the ability to call preferred stock. This advantage allows them to take advantage of dropping interest rates. When interest rates do drop, corporations can call in their existing preferred stock and issue new stock at a lower dividend yield. However, just because the option to call exists does not mean a company necessarily will do so. On the other hand, the fact that a company may have this option can be added risk for an investor who would prefer to keep earning higher yielding dividends.

Convertibility

If a preferred stock is convertible, this means that there is an existing option to convert the share to regular common stock. Sometimes this option lies with the investor and sometimes it lies with the issuing company. There are also instances when shares automatically convert on a certain, specified date. Depending on the price that the common stock currently trades at, this convertibility can be beneficial to preferred shareholders.

Who Invests in Preferred Stock?

The majority of the time, preferred stock investors are institutions rather than retail investors like you or me. There are often tax benefits that help institutions that are not available to individual investors. This makes preferred stock attractive to these institutions. In general, institutional investors buy stock in bulk. As a result, issuing companies often have the chance to raise a lot of capital all at once. Sometimes even pre-IPO companies issue preferred stock.

Companies issue preferred stock for different reasons. Often companies with great or low-end credit ratings may issue shares due to various tax and other advantages they accrue. Shares may be treated differently for tax consequences and balance sheets, so this can be advantageous as well. Sometimes major corporations issue preferreds rather than more common stock or bonds to raise additional funds depending on their current situation.

Concluding Thoughts

Although retail investors are less likely to purchase shares of preferreds rather than common stock or bonds, it’s still good for your financial literacy and education to know about all of the various investment vehicles out there. And there may be some circumstances when even a retail investor buys shares of preferreds.

If you’d like to learn more about various types of assets and investments, make sure to sign up for our free Investment U e-letter by subscribing in the signup box below.

Now that you know much more about preferreds, you can make wise investment decisions if they are right for you. At the end of the day, make sure to balance your portfolio with a proper mix of asset classes with respect to your personal time horizon and risk tolerance. If preferred stock makes sense for your portfolio go ahead and research individual issuances to make the best possible investment decision.


About

Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.

He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.

His primary interests at Investment U include personal finance, debt, tech stocks and more.

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