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Investing In Preferred Stock vs. Common Stock

Posted on Friday, February 28th, 2020 by Matthew Sweeney

Investing In Preferred Stock vs. Common Stock

Stock represents ownership in a company. Preferred stock represents ownership that often grants the stockholder a guaranteed claim to dividends and a stronger claim on company assets. Preferred stock is therefore much different than common stock, which grants the shareholder voting rights on company policies, but provides a weaker hold on company assets and no guaranteed claim to dividends.

Common Stock vs Preferred Stock

Preferred stock and common stock differ in a few key areas.

An easy way to conceptualize the difference between common stock and preferred stock is to think of common stock as a general admission ticket, and preferred stock as a VIP pass.

As its name suggests, common stock is much more common than preferred stock. Common stock is bought and sold on the stock market, and trades are facilitated by a stock brokerage. You can also buy preferred stock through a brokerage, but unless you specifically seek out preferred stock the default assumption is that you’re buying common stock. If you are looking for preferred stock, the method for doing so will vary from brokerage to brokerage, so you’ll need to do a little research and preparation. Many companies do not even issue preferred stock at all.

Preferred stockholders will be paid dividends before common stockholders—even if there’s nothing left for common stockholders to get. The dividends provided by shares of common stock are variable, depending on company profits and decisions made by the board of directors.

By contrast, dividends associated with preferred stock are fixed in perpetuity. Some companies do not pay dividends to common stockholders at all. In fact, the fixed nature of preferred stock dividends is one reason why some investors choose preferred stocks over common stocks.

Moreover, common stock—if it pays dividends—has a uniform, albeit fluctuating, dividend yield that is the same for each and every share. But there can be different classes of preferred shares when it comes to dividend yield. Some preferred stocks will have higher dividend yields than others, even if they are all issued by the same company. The different classes of preferred stock will be listed on the brokerage for investors to choose which class they want to purchase.

If a company needs to file for bankruptcy or runs into any other type of financial trouble that involves liquidating its assets, creditors will be paid first, then bondholders, and then preferred stock shareholders. Common stock shareholders are last in line. If the company folds entirely, preferred stockholders have a greater set of protections guarding their investment than common stockholders.

Prices of common stock are based on several factors, not the least of which are the stock market and the perceived value of the issuing company. This means that common stock prices can fluctuate wildly in response to a number of external factors, or even just because investors believe the company has a particular value. One statistic that indicates a common stock’s deviation from its true price is the price to earnings ratio, which compares the stock price to the annual net income of the company per share.

Preferred stock tends to be far more stable. One reason is that prices do not fluctuate based on supply and demand, because investors are not interested in the price—and consequently, their activity does not drive prices up or down; instead, investors are interested in the fixed dividends offered by preferred stock. Preferred stocks are also rated by credit rating agencies for their financial strength, a practice that is also applied to corporate bonds. They may have limits on ownership, and some of them come with clauses that allow the issuing company to recall the shares. All these traits make preferred stocks more like bonds than stocks, and as a result, their behavior is more stable.

The downside of this stability is that investors cannot capitalize on price increases, as they can with common stock. But again, investors who purchase preferred stock are not normally looking to capitalize on market movements; they are looking for dividends.

Shares of common stock give the shareholder voting power in terms of important company decisions like who gets placed on the board of directors. Their opinion—as expressed by a vote—can influence company moves like mergers and acquisitions, and even shape company policies. One share of stock is equivalent to one vote, so an investor, financial institution, or company that owns a certain number of shares can exert sizeable influence in shaping a company’s policy.

However, preferred stock usually carries no voting rights. At the same time, preferred stockholders are guaranteed the dividend indicated by their asset class and have a greater claim to the assets of the company in the event of liquidation. Again, investors tend to buy preferred stock because of its fixed dividends, and not because they want to influence the direction of company policies.

Common shares cannot typically be converted into preferred shares, but preferred shares can sometimes come with the option for shareholders to convert them into common shares—which is particularly useful if they own a sizeable number of preferred shares and suddenly want to influence company policy, or if they want to capitalize on a wild increase in common stock prices for that company.

There is always some measure of risk that investors undertake when buying stock. In terms of a risk scale, preferred stock would seem to be far more stable than corporate bonds (essentially promissory notes issued by a business to raise capital, with a promise to repay investors based on future returns), and even more stable than common stock.

Common stock market prices can fluctuate based on a number of factors that are out of the control of investors. Though some industries are famously stable (such as consumer staples like food, beverage, and food and beverage distribution) and others are notoriously unstable (such as speculative new enterprises like AI, marijuana, and biotech in recent years), the truth of the matter is that common stock prices go up and down.

By contrast, preferred shares do not have wild price fluctuations, but that means investors will also not be able to capitalize on price increases. So, while their risk is minimized, their potential reward, at least in terms of gaining from price movements, is also minimized.

But investors do not buy preferred stock for its price movements. They buy it for dividends—and in terms of dividends, preferred stocks are more stable than common stocks. The dividend yield of common stock is a floating rate; the dividends not only depend on company performance, but also on allocations decided on by the board of directors. And in fact, if they choose to reinvest company profits into expanding the company, investors of common stock will lose out on their dividend payments.

By contrast, preferred stock dividends are promised at a fixed rate by the company, and even if the company has to defer their dividend payments, the investors will eventually get them in most cases. Moreover, preferred stock has an added layer of security in that if the company goes bankrupt or closes down, shareholders of preferred stock have first rights to company assets, while holders of common stock have no guarantee of anything. To that end, there are many ways in which preferred stock is a much less risky investment vehicle than common stock.

Why Do Companies Issue Preferred Stock?

Stock is one of the easiest ways for companies to quickly raise capital. By selling off shares of the business, a company can raise millions if not billions of dollars in its initial public offering (IPO). These funds can then be used to finance a project, expand into a new territory or new line of business, or eliminate debt.

Companies also like to issue stock, preferred or common, because it allows them to raise capital without getting into debt. This, in turn, lowers their debt to equity ratio and provides greater leverage for future financing needs. The debt to equity ratio is a common statistic used to assess the stability of a business. The more debt a company has in comparison to its equity (e.g. assets), the riskier an investment it seems, and the less attractive it appears to investors. Conversely, the more equity a company has in comparison to its debt makes it look far more stable and more attractive to future investors. To that end, stocks can help companies manage their balance sheet.

When it comes to issuing stock, companies can be selective about the type of relationship they want with shareholders. They can choose to issue corporate bonds, preferred stock, or common stock. That last option puts potential voting power in the hands of investors to sway company policy, and it also carries the potential to put a sizable amount of voting power into the hands of one investor—whether that investor is an individual or a rival company.

In fact, it is the latter type of investor that most concerns companies in need of cash. A rival company may attempt a hostile takeover by buying up a controlling number of shares and obtaining huge amounts of voting power in terms of company policy. By issuing preferred stock, a company can protect its current structure, policies, and even existence by preventing another company from purchasing a large number of common stock shares.

At the same time, preferred stocks are confusing to many investors, especially investors of the casual retail variety. So, while issuing common stocks presents the risk of another company purchasing a controlling share, it also makes it easier for the company to raise more capital since common stocks will be in higher demand.

Preferred stocks can also be callable, which means that the company can reserve the right to buy the shares back at a certain preselected price (at par value). This is a far more attractive option for companies to exercise than having to buy back shares of common stock that have soared in price since they were initially offered on a publicly-traded exchange. This would be a loss for the company.

Because bonds create a repayment obligation while preferred stocks are only a promise to pay dividends, preferred stocks are often a more attractive way to raise capital without compromising a company’s appearance of stability. In fact, if a company defaults on its corporate bonds, it can launch them into bankruptcy. By contrast, if a company is unable to make dividend payments to preferred stockholders, it can defer the payment of dividends until it’s financially able to meet their dividend obligations.

What Are the Different Categories of Preferred Stock?

As mentioned, there are different categories of preferred stock.

Cumulative preferred shares accrue dividends if a company defers on paying them, and the company will have to pay these dividends to cumulative preferred shareholders before they pay dividends to common stockholders.

Non-cumulative preferred shares do not carry the same promise of accrual as cumulative preferred shares. With non-cumulative preferred shares, if the company is unable to pay dividends, they will not accrue, and the shareholder may never get them (in this way, they are more similar to common stocks).

Trust-preferred shares are offered by a company that has created a trust and issued its preferred stock through that trust. These trust-preferred shares are often funded by debt securities like corporate bonds and frequently mature at the same time.

Convertible preferred stock can be converted into a specific number of shares of common stock.

Exchangeable preferred stock can be exchanged for another type of security, like common stock.

How Is Preferred Stock Rated?

Preferred stocks are like bonds in that they are rated by a credit reporting agency such as Moody’s Investors Service or Standard & Poor’s Corporation. The ratings provided by these credit-reporting agencies help investors gauge the creditworthiness of the issuing company and its ability to repay debt. Ratings of BBB or higher on the rating scale of Standard & Poor’s Corporation indicate investment-grade material (that is, safe for investing), while lower than BBB indicates a risky stock. Baa3 ratings and above on the Moody’s scale indicate investment-grade stock, while anything lower indicates risk.

It’s important to realize that ratings can fluctuate, even if dividends of a preferred stock are set at a fixed rate. Though the solid dividend rate provides a reliable fixed income for investors, companies unable to pay a dividend to their investors can postpone dividend payments. That’s why a rating is important for investors to consider when looking at preferred stocks. These ratings take into account whether or not a preferred stock is actually a good buy, and this is especially useful for investors in light of the fact that shares of preferred stock do not have a market price that fluctuates to the extremes of common stock. The fluctuations in common stock can be a good indicator of a company’s relative strengths and weaknesses in terms of investment potential. Preferred stock prices do not change like common stock prices, and thus investors need ratings to give them guidance.

Who Should Buy Preferred Stock?

Investors do like preferred stock because it offers a consistent dividend yield without having to wait for it to reach maturity (as with a bond). Moreover, while its potential return may not be as great as a corporate bond, it carries far less risk. Corporate bonds are backed by a company’s ability to repay bondholders, and usually based on the potential return from future operations.

Investors might also want preferred stock over corporate bonds because the former carries certain tax advantages. The dividends facilitated by preferred stock are qualified by the IRS and taxed at a special rate that is similar to long term capital gains, as opposed to corporate bonds which are taxed as ordinary income.

In fact, most investors will pay around 15% taxes on dividends from their preferred stock. If they are in the ordinary tax bracket of taxpayers who normally pay 15% taxes or below, they don’t pay taxes on preferred stock dividends at all. This makes preferred stocks a more appealing option than long-term bonds, which not only have long-term interest rates that can take a while to mature, but also can trigger almost punitive taxation.

However, it’s important to realize that there are some types of preferred stock that do not have this special tax advantage, such as preferred stock issued by a bank’s trust. These preferred stocks can be taxed higher, based on the investor’s income—and taxes for some investors can be as high as the 37% maximum federal rate.

These points should only highlight the need for non-institutional investors (e.g. casual retail investors) to consult with an investment professional about the idea of purchasing preferred stock. Not only is it confusing to navigate the ins and outs of preferred stock, but issues around taxation can make all those hard-earned gains disappear.

Preferred Stock ETF

Investing in preferred stocks is one of the trickier strategies to execute in the stock exchange. To that end, individuals looking to capitalize on preferred dividends might consider exchange-traded funds that focus on preference shares (another name for preferred stock). Preferred stock ETFs are great ways to benefit from the higher yields of dividend-focused preferred stock, without having to navigate some of the fine print complexities of stock dividends that can be competently accounted for by institutional investors.

An exchange-traded fund is somewhat like a blend between stocks and mutual funds. Like a mutual fund, an exchange-traded fund is a pooled investment vehicle where each investor can access the financial power of a diverse range of securities, with a much smaller investment more likely within their means. But retail investors contribute to a mutual fund by investing cash amounts of their choosing. By contrast, an ETF actually has a market price and is traded on the stock market much like a stock.

One such ETF to look at is the SPDR Wells Fargo Preferred Stock ETF (PSK), with many of its holdings invested in dividend income producing giants in the financial sector like Citigroup, PNC, and HSBC—along with some energy and utility companies like AT&T and Duke Energy. The Invesco Preferred ETF (PGX) is another such ETF that investors should consider. Many of its holdings are also in financials like Wells Fargo and Bank of America. For investors looking to tap into a global market without having to worry about depository shares, the iShares International Preferred Stock ETF (IPFF) will allow them to access some fixed income power from institutions like the Royal Bank of Canada or Swiss real estate conglomerate Klovern AB.

Investing in Preferred Stock

Investors who purchase preferred stock are not concerned about the most volatile stocks or the hottest trending names on Wall Street. Instead, they are in search of a steady income achieved in part with the assistance of monthly dividend payers who issue company profits to preferred stockholders before any other investors—like those who hold common stock.

Preferred stock takes a dividend investing strategy to a whole new level. However, investors really have to be committed to the idea of dividends and accept the possibility of having their shares called back by the issuing company. Moreover, they won’t be able to watch the value of their stock portfolio increase over time, since preferred stock does not fluctuate in price like common stock.

Not all companies issue preferred stock. However, for those that do, investors can tap into the monetary power of a greater hold on dividend increases with preferred stock. Though preferred stock does not grant the shareholders any voting rights, this is most likely okay for investors that are not looking to stage a hostile takeover of another business or to sway company policy.

In short, preferred stock is a wonderful investing option to explore for investors with a little more experience who don’t need the fluidity of common stocks and have a little more familiarity with the process of fundamental analysis of a company and knowledge of the market. For casual retail investors, however, exploring preferred stock might best be done with the assistance of a competent financial advisor.

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