Preferred Stock

Preferred Stock

Preferred stock is a class of equity that gives holders priority over common shareholders for dividends and asset distributions but typically offers limited or no voting rights. It combines features of both stocks and bonds, making it attractive to investors seeking steady income with some equity upside.

Key takeaways

• Preferred shareholders have priority for dividends and liquidation proceeds over common shareholders, but they rank behind bondholders.
• Dividends on preferred stock are often fixed or tied to a benchmark rate and may be cumulative or noncumulative.
• Preferred shares usually carry limited or no voting rights and may be callable or convertible into common stock.
• Preferred stock behaves like a hybrid: more income stability than common stock, less capital appreciation potential.

How preferred stock works

Preferred shares usually pay regular dividends (monthly, quarterly, or annually). Dividends can be:
* Fixed (a stated percentage of par value)
* Adjustable (tied to an index or benchmark, e.g., SOFR)
* Participating (may receive extra payments based on company performance)

Payment of dividends is at the board’s discretion, except that cumulative preferred stock accrues unpaid dividends that must be paid before common shareholders receive dividends. Preferred shares are often perpetual (no maturity), meaning investors must sell shares to recover capital unless the issue is callable.

Main types of preferred stock

• Prior (senior) preferred: Earlier-issued preferred shares that take precedence over later preferred issues.
• Preference preferred: A tiered ranking among preferred issues (e.g., most senior, second senior).
• Perpetual preferred: No maturity date; capital is returned only if shares are sold or called.
• Convertible preferred: Can be exchanged for a specified number of common shares under set conditions.
• Cumulative preferred: Unpaid dividends accumulate and must be paid before common dividends.
• Noncumulative preferred: Missed dividends are not carried forward.
• Participating preferred: May receive additional dividends tied to company performance in addition to the regular dividend.

Preferred stock vs. common stock

• Dividends: Preferred — generally fixed and prioritized; Common — discretionary and subordinate.
• Voting rights: Preferred — typically limited or none; Common — usually voting rights.
• Price appreciation: Preferred — limited upside, behaves more like fixed income; Common — greater potential for capital appreciation.
• Liquidation: Preferred holders are ahead of common shareholders but behind creditors and bondholders.

Preferred stock vs. bonds

Similarities:
* Both can provide regular cash payments and are often issued with a par value used to calculate payments.

Differences:
* Dividend payments on preferred stock can be reduced or suspended without causing issuer default; bond interest payments are contractual obligations.
* Bonds usually have a maturity date; most preferred stock is perpetual.
* In liquidation, bondholders get priority over preferred shareholders.
* Tax treatment differs: preferred dividends may receive favorable tax treatment relative to interest income for some investors.

Voting rights, callability, and convertibility

• Voting: Preferred shares usually lack voting rights; in some cases voting rights may be triggered if dividends are not paid.
• Callability: Many preferred issues are callable, meaning the issuer can repurchase shares at a preset price after a specified date. Call risk is important if interest rates fall.
• Convertibility: Convertible preferred shares can convert into common stock based on predefined terms. Conversion may be voluntary, mandatory, or board-triggered.

Tip: Check whether a preferred issue is callable or convertible before investing, since these features affect income stability and upside potential.

Who buys preferred stock

Institutional investors are common buyers—especially at issuance—because preferred stock can be issued in large blocks and may offer tax or regulatory advantages. Retail investors buy preferred shares for income and relative stability compared with common equity; financial-sector companies are frequent issuers.

Advantages and disadvantages

Advantages:
* Priority on dividends and liquidation over common stock.
* Typically steady income, often with higher yields than bonds from the same issuer.
* Hybrid characteristics: some equity upside, bond-like income.

Disadvantages:
* Limited capital appreciation versus common stock.
* Limited or no voting rights.
* Dividends can be suspended without constituting default.
* Callable risk can cap upside if shares are redeemed when interest rates fall.

Example

A company issues a 7% preferred at $1,000 par value. The investor would receive $70 annually (or $17.50 quarterly). The share may trade near par and behaves more like a fixed-income security, attracting investors seeking income.

Bottom line

Preferred stock is a hybrid equity instrument that prioritizes income and claims in the capital structure over common stock, at the cost of voting rights and most capital appreciation. It is suitable for investors seeking steady dividend income with some equity exposure but carries risks such as dividend suspension, callability, and issuer credit risk.