As consumers, we like to have “preferred” status. Companies know this and come up with all kinds of ways to allow us to feel like insiders. Whether through loyalty clubs, complimentary upgrades, or access to premium information that non-preferred customers can’t get, marketers think of all kinds of ways to reward us for our frequent purchase of their goods and services, or in some cases for our willingness to pay a premium price.
In the investing world, there is also a way for some investors to get preferential treatment. This can happen when they buy preferred stock. Preferred stock, which is also known as a hybrid security, has good points and bad points.
In this article, we’ll define preferred stock and explain the features that make them different from common stock. We’ll also review the different types of preferred stock and review the benefits and the risks associated with ownership of preferred stock.
What is preferred stock?
Preferred stock is a class of stock that has a higher (or preferred) claim to the assets and earnings of a corporation than owners of common stock. By definition, all shareholders of a corporation whether they own 1 share or 1,000,000 shares are a part owner of the company. Preferred stockholders move to the front of the line for many reasons.
Preferred stock is frequently referred to as a hybrid security. This is because preferred stock, while considered equity, also has elements of debt that make them similar to a bond. Let’s take a closer look at what that means.
Preferred stock is equity– Preferred stock is considered equity because like common shares, shares of premium stock can increase in price. However, because preferred shares have a face value, like bonds, their market value does not increase in the same way as common stock. Instead, the market value of preferred stock behaves like a bond, increasing as interest rates decline and decreasing as interest rates increase.
Preferred stock is debt– Shareholders of preferred stock are entitled to receive a regular fixed-rate dividend. Just like bondholders. Each share of preferred stock has a par value, like a bond, that is tied to a dividend yield. For example, if you are buying shares of a preferred stock with a 5% dividend and the market value was $50, the dividend would be $2.50/share (typically paid quarterly or annually).
How is preferred stock different from common stock?
Common stock is strictly an equity investment. The value of a common share is based exclusively on the market. If the stock pays a dividend, the dividend yield is also subject to fluctuation. Owners of common stock have voting rights at shareholder meetings.
Preferred stock, by contrast, has elements of equity, but behaves more like a bond. For example, every share of preferred stock has a face value like a bond. The dividend yield of a preferred stock, which is generally higher than the dividend yield of common shares, is a percentage of this face value. In this way, the market value of a preferred share of stock only reflects the value of the stock in the marketplace. So preferred stock may have a higher face value than its market value. In exchange for this guaranteed dividend payment, preferred stock owners forfeit voting rights.
Can the market price of preferred shares change?
The market price of preferred shares can change, but because they are hybrid investments, they behave more like a bond. This is because the key benefit of owning preferred shares is the regular, fixed dividend payment. This means that when interest rates rise, the market value of the shares has to decline to bring the fixed dividend payment in line with the new interest rate. Conversely, when interest rates decline, the market value of each share has to rise.
Who buys preferred stock?
Almost all preferred stock is purchased by institutional investors. The primary reason for this is that the Internal Revenue Service offers United States corporations a dividend received deduction. This deduction allows them to exclude a high percentage, 70%, of dividend income from their taxable income.
So, if preferred shares behave more like bonds than equities, but put a company on the hook for a larger dividend payment, why doesn't the company simply issue a bond offering? The answer to that lies in the characteristics of a preferred stock that offer both benefits and risks. For example, as we’ll review more below, a company can legally suspend dividend payments indefinitely if they have cash problems. Also, because most shares of preferred stock are owned by institutional investors, they can be easier to market at the initial public offering (IPO).
Benefits of owning preferred stock
The ability to receive a regular dividend is generally considered a compelling benefit to owning the preferred stock. Preferred stock owners have priority over common stockholders. This means should a company have to dissolve, any money left over after creditors are paid would go to preferred shareholders before common shareholders would get paid.
As we also mentioned above, corporate investors can get a dividend received deduction, which allows them to exclude most of the dividend income they receive.
Risks involving preferred stock
Most of the risks involving preferred stock center around the financial health of the issuing corporation. If the company is facing a cash crunch, they can opt to suspend dividend payments to preferred shareholders. While it’s true that all missed payments would have to be made to preferred shareholders before they went to common shareholders, a company is under no legal obligation to make a dividend payment. In addition to being a risk of owning preferred stock, it is also a key distinction between preferred stock and bonds.
Another risk that is also a potential benefit is that preferred stock typically includes a call provision. This gives a company a right to buy back the preferred shares at their discretion. For example, several years after issuing preferred shares to fund a capital project, a company may be generating large amounts of cash from that investment. In this case, buying back preferred shares will take away the commitment of making those regular dividend payments. While this can be a negative for investors, the potential benefit is that in almost every case, the prospectus that goes along with the shares will mandate that shareholders be compensated for their shares at a price above the face value they paid for the shares.
Types of preferred stock
Callable Shares– This type of preferred share gives the company the option to buy back the shares at a fixed price at any point in the future at their discretion. Although in almost every case, the company will mandate that shareholders will be repaid at a price above the face value of their preferred shares, callable shares provide a greater benefit to the issuing company because they are putting a cap on the stock’s value. In virtually all cases, callable shares do not have a maturity date, like a bond. If they do have a maturity date, it is set so far in the future that it will be unlikely to ever be honored.
Convertible Shares– As the name suggests, this type of preferred share gives owners an option to exchange their preferred shares for common shares. In a way, this makes them the opposite of callable shares. With callable shares, the offering company has the option. With convertible shares, the shareholders have the option. This can be profitable if the market value of the common shares increases, making the capital gain more attractive than the fixed dividend payment. Most convertible shares have rules attached to them. Here’s an example to show how a conversion may work.
An investor purchases ten shares of preferred stock at $40 per share for an initial investment of $400. If the prospectus indicates that one share of preferred stock can be converted to three shares of preferred stock, then the investor can profit when the price of a common share rises above $14 per share ($14 x 30 = $420). Once preferred shares have been converted to common shares, they cannot be converted back into preferred shares.
Cumulative Shares– One of the risks that we cited above was the risk of a company coming upon a decline in revenues or other misfortunes that would prompt them to suspend the fixed dividend payment. Cumulative shares offer protection for the shareholder by mandating that any unpaid dividends be paid to preferred shareholders before any other dividends are paid. So if a shareholder is holding preferred shares that are guaranteeing a $6 per share dividend, but the company does not pay the dividend for three consecutive years, in the fourth year when the company is in a position to issue a dividend, these shareholders must be paid $24 ($6 x 4) before any dividend can be paid to common stockholders.
Participatory Shares– This type of share offers the potential for investors to receive an additional profit guarantee above and beyond the fixed dividend rate. With these shares, the investor is guaranteed additional dividends if the issuing company meets outlined financial goals. This would allow shareholders to receive dividend payments higher than their normal fixed rate.
Should retail investors be interested in preferred stock?
This is a tricky question. For income investors, the allure of a higher dividend return than they could get from common stocks or bonds may be a very attractive option. However, preferred stock does come with certain drawbacks that could include they are tougher to sell or they may be able to be called by a company. Another thing to remember is that preferred shares are typically issued by corporations on either end of the credit spectrum. If you're buying from a company with a very good credit rating, then there is less risk of not receiving your dividend payment. However, if a company has a poor credit rating, you could find your expected dividend payments to be suspended for an indefinite period of time.
The bottom line on the preferred stock
Preferred stock is one of many options companies have to raise capital. Because they have features of both equity and stock, they are considered hybrid investment vehicles and offer benefits and risks for both the issuing companies and investors.
The primary way a preferred stock is different from common stock is that preferred stock offers a fixed-rate dividend. This dividend typically has a higher yield than what investors can receive from owning common shares. This dividend must also be paid before common shareholders receive their dividend payment. In return for this fixed dividend, preferred share owners relinquish voting rights. This can be a desirable feature for issuing companies.
Preferred stock also does not appreciate in value the same way as common shares. And, there is the potential that because of market dynamics, owners of common shares could get a dividend yield that rises higher than the fixed dividend yield of preferred shares.
There are four primary types of preferred stock: Callable shares, convertible shares, cumulative shares, and participatory shares. Each offers different features that investors should be aware of. In general, preferred shares are owned by institutional investors. Retail investors, particularly income investors, may find the higher yields appealing, but may also find that the restrictions may be too limiting.