What Are Preferred Stocks? A Complete Guide for Investors

Introduction

Preferred stocks are a type of equity security that combines some characteristics of common stocks and bonds. When investors purchase preferred shares, they generally receive an ownership interest in a company and may receive dividends before common shareholders. However, preferred shareholders usually have fewer voting rights than common shareholders.

The word “preferred” refers mainly to the priority these shareholders receive in certain situations. For example, preferred shareholders generally have priority over common shareholders when it comes to receiving declared dividends and receiving assets if a company is liquidated.

Preferred stocks can therefore appeal to investors who are interested in income and a higher claim on company assets than common shareholders have. At the same time, they carry risks, including interest-rate risk, credit risk, price volatility, and the possibility that dividends may be reduced, suspended, or not guaranteed. Understanding how preferred stocks work is important before deciding whether they belong in an investment portfolio.

What Are Preferred Stocks?

Preferred stocks, also called preferred shares, are securities that represent an ownership interest in a company. They are generally considered equity rather than debt. The main feature that distinguishes preferred stock from common stock is the priority given to preferred shareholders.

In general, preferred shareholders have:

• Priority over common shareholders for declared dividends
• Priority over common shareholders in liquidation
• Limited or no regular voting rights in many cases
• A dividend that may be fixed or determined according to specific terms
• Potentially less opportunity for capital appreciation than common stock

For example, imagine a company has both common shares and preferred shares. If the company declares a dividend for both classes, preferred shareholders generally receive their specified dividend before common shareholders receive dividends.

However, preferred shareholders are still below bondholders and other creditors in the company’s capital structure. This distinction is important: preferred stock may offer greater priority than common stock, but it is not the same as a bond.

How Do Preferred Stocks Work?

When a company issues preferred stock, investors purchase those shares and become preferred shareholders. The terms of the preferred stock are normally established when the shares are issued.

These terms can include:

• Dividend rate
• Dividend payment schedule
• Whether dividends are cumulative
• Whether the shares can be converted into common stock
• Whether the company can redeem or call the shares
• Liquidation preference
• Voting rights
• Other special rights

Suppose a preferred share has a stated annual dividend of $5. If the company declares the dividend according to the terms of the security, an investor holding 100 shares would be entitled to $500 in annual dividends.

The actual market price of the preferred stock can move above or below its original issue price. Changes in interest rates, company financial conditions, investor demand, and other market factors can influence its price.

Preferred Stock Dividends

One of the biggest attractions of preferred stocks is their dividend structure.

Preferred shares often have a stated dividend rate or amount. This can make their income characteristics more predictable than those of common stocks, although the dividend is not necessarily guaranteed.

For example, a preferred stock might have a $25 liquidation preference and a 6% annual dividend rate. Its annual dividend would be:

$25 × 6% = $1.50 per share

An investor holding 200 shares would receive $300 annually if the dividend is declared and paid according to the terms.

However, investors should always examine the specific terms of a preferred security. A dividend may be cumulative or non-cumulative, and the company may have certain rights concerning dividend payments.

Cumulative vs Non-Cumulative Preferred Stocks

Preferred stocks can differ significantly in how unpaid dividends are treated.

Cumulative Preferred Stock

With cumulative preferred stock, if a company misses a required preferred dividend, the unpaid amount generally accumulates. Before common shareholders can receive dividends, the company generally must first address the accumulated preferred dividends according to the security’s terms.

For example, suppose a preferred stock pays $1 per share annually. If the company does not pay the dividend for two years, $2 per share could accumulate. This feature provides additional protection for preferred shareholders.

Non-Cumulative Preferred Stock

With non-cumulative preferred stock, missed dividends generally do not accumulate. If the company skips a dividend, preferred shareholders may not have the right to recover that missed payment later. This makes the specific terms of the security particularly important when comparing preferred stocks.

Preferred Stocks vs Common Stocks

Preferred and common stocks are both forms of equity, but they provide different rights and characteristics.

Common shareholders generally have greater potential to benefit from a company’s long-term growth. Preferred shareholders, meanwhile, typically receive greater priority for dividends and liquidation proceeds.

Neither security is automatically better. The appropriate choice depends on an investor’s objectives, risk tolerance, and portfolio structure.

Preferred Stocks vs Bonds

Preferred stocks can look similar to bonds because both may provide regular income.

However, they are fundamentally different securities. A bond represents debt. The company borrows money from investors and has an obligation to make payments according to the bond’s terms. Preferred stock represents equity ownership.

In a company’s capital structure, bondholders and other creditors generally have priority over preferred shareholders if the company becomes insolvent. Preferred stock may therefore provide income characteristics similar to fixed-income investments while retaining equity-related risks.

Types of Preferred Stocks

There are several types of preferred stocks. Their features can vary substantially.

1. Cumulative Preferred Stock

As discussed earlier, cumulative preferred shares generally allow unpaid dividends to accumulate.

2. Non-Cumulative Preferred Stock

Non-cumulative preferred shares generally do not accumulate missed dividends.

3. Convertible Preferred Stock

Convertible preferred shares give investors the ability, subject to the terms, to convert preferred shares into a specified number of common shares.This can provide a combination of preferred-stock income characteristics and potential participation in common-stock price appreciation.

4. Callable Preferred Stock

Callable preferred stock allows the issuing company to redeem the shares under specified conditions. This can benefit the company because it may be able to replace expensive financing when market conditions change.

For investors, however, call provisions can create reinvestment risk. If a company redeems attractive preferred shares, investors may need to find another investment with comparable income.

5. Participating Preferred Stock

Participating preferred shares may allow investors to receive their preferred dividend and potentially participate in additional distributions under specific conditions. The exact rights depend on the security’s terms.

6. Perpetual Preferred Stock

Perpetual preferred shares generally do not have a fixed maturity date. They may continue indefinitely unless redeemed by the issuer or otherwise terminated according to their terms.

Why Do Companies Issue Preferred Stocks?

Companies can issue preferred stock for several reasons.

Raising Capital

Preferred stock allows companies to raise capital without taking on traditional debt.

Flexible Financing

Preferred shares can have terms that provide companies with financing flexibility while giving investors specific rights.

Managing Capital Structure

Companies may use preferred shares as one component of their overall capital structure alongside common equity and debt. Preferred stock can therefore serve as a middle ground between traditional debt and common equity from a financing perspective.

Advantages of Preferred Stocks

Preferred stocks can offer several potential advantages.

Priority for Dividends

Preferred shareholders generally have priority over common shareholders for declared dividends.

Potentially Predictable Income

Many preferred stocks have predetermined dividend rates, which can make their income characteristics easier to understand than common stocks whose dividends can vary substantially.

Liquidation Preference

If a company is liquidated, preferred shareholders generally have priority over common shareholders when distributing remaining assets, although creditors generally come first.

Diversification

Preferred stocks can provide another type of security for investors who want to diversify beyond common stocks and traditional bonds.

Potentially Attractive Income

Some preferred securities are designed with income generation as a major feature. However, investors should not assume that a higher dividend automatically means a better investment. Higher yields can sometimes reflect higher risks.

Risks of Preferred Stocks

Preferred stocks are not risk-free investments.

Interest-Rate Risk

Many preferred stocks are sensitive to changes in interest rates.

When market interest rates rise, existing preferred shares with fixed dividend rates can become less attractive compared with newly issued securities offering higher rates. Their market prices may therefore decline.

Credit Risk

If the issuing company experiences financial difficulties, the value of its preferred stock may fall.

Dividend Risk

Preferred dividends may have strong contractual or structural protections depending on the security, but investors should not treat them as equivalent to guaranteed interest payments on high-quality debt.

Limited Capital Appreciation

Preferred stocks may not benefit from company growth to the same extent as common shares.

Call Risk

If preferred stock is callable, the issuer may redeem it under the specified conditions. This can limit an investor’s ability to continue receiving an attractive dividend.

Market Risk

Preferred shares trade in financial markets and their prices can fluctuate.

Liquidity Risk

Some preferred stocks may have lower trading volume than heavily traded common stocks, which can make buying or selling more difficult at a desired price.

How Are Preferred Stocks Valued?

The market value of preferred stock depends on several factors.

These include:

• Dividend rate
• Current market interest rates
• Creditworthiness of the issuer
• Call provisions
• Conversion features
• Investor demand
• Market liquidity
• Overall economic conditions

For a simple fixed-dividend preferred stock, investors may compare its dividend yield with yields available from other investments. For example, if a preferred stock pays $2 annually and trades at $25, its current dividend yield is:

$2 ÷ $25 × 100 = 8%

If its price rises to $30 while the dividend remains $2, the current yield falls to approximately 6.67%. This illustrates why market price and dividend yield are closely connected.

What Is Liquidation Preference?

Liquidation preference is an important feature of preferred stock. It refers to the amount or priority a preferred shareholder is entitled to receive before common shareholders in a liquidation, subject to the security’s terms and the company’s available assets.

For example, suppose a preferred stock has a liquidation preference of $25 per share. If the company is liquidated and sufficient assets remain after satisfying higher-priority claims, preferred shareholders may have a claim based on that preference before common shareholders receive anything.

However, liquidation preference does not mean preferred investors are guaranteed to recover their money. If the company does not have enough assets after paying creditors and other higher-ranking claims, preferred shareholders can still suffer losses.

Do Preferred Stockholders Have Voting Rights?

Voting rights depend on the specific preferred stock. Common shareholders generally have voting rights on important corporate matters. Preferred shareholders often have limited or no ordinary voting rights.

However, preferred shareholders may receive voting rights under certain circumstances.
For example, the terms may provide voting rights if the company fails to pay dividends for a specified period or if it proposes changes that affect the rights of preferred shareholders. Investors should always read the security’s offering documents to understand its exact voting provisions.

How Do Investors Make Money From Preferred Stocks?

Investors can potentially earn returns from preferred stocks in two main ways.

Dividend Income

The primary attraction is often dividend income. If a preferred share pays a regular dividend and the investor continues to hold the security under the applicable terms, those payments can provide income.

Capital Gains

Preferred shares can also increase in market value. For example, if an investor buys preferred stock for $25 and later sells it for $28, the investor has a $3 gain per share, excluding dividends and transaction costs. However, price appreciation is not guaranteed.

Are Preferred Stocks a Good Investment?

Preferred stocks can be useful for some investors, but they are not automatically suitable for everyone.

They may be worth considering when an investor is interested in:

• Dividend income
• Greater priority than common shareholders
• Portfolio diversification
• Securities with defined dividend terms
• A combination of equity and income characteristics

Investors focused primarily on long-term capital growth may prefer common stocks or broad equity funds because common shares generally have greater participation in a company’s growth. The decision should depend on the individual security’s terms and the investor’s overall financial objectives.

Common Mistakes When Investing in Preferred Stocks

Beginners can make several mistakes when evaluating preferred shares.

Looking Only at Dividend Yield

A high yield does not automatically mean a low-risk investment.

Ignoring Call Provisions

Investors should check whether the issuer can redeem the preferred shares.

Assuming Dividends Are Guaranteed

Preferred dividends have specific legal and contractual characteristics that vary by security. They should not automatically be treated like guaranteed bank interest.

Ignoring Interest Rates

Fixed-rate preferred stocks can be particularly sensitive to changes in market interest rates.

Forgetting About the Issuer

The financial strength of the issuing company matters.

Comparing Only the Share Price

The price alone does not tell you whether a preferred stock is attractive. Investors should examine dividend terms, yield, credit quality, call features, conversion rights, and other conditions.

Frequently Asked Questions

1. What are preferred stocks in simple terms?

Preferred stocks are equity securities that usually give investors priority over common shareholders for declared dividends and liquidation proceeds. They often have predetermined dividend terms but may provide fewer voting rights.

2. Are preferred stocks safer than common stocks?

Preferred stocks generally have greater priority than common stocks for dividends and liquidation, but they are still exposed to market, company, interest-rate, and other risks. They are not automatically safer in every situation.

3. Do preferred stocks pay dividends?

Many preferred stocks are designed to pay dividends, often at a stated rate. However, the exact payment terms depend on the security.

4. Can preferred stocks lose value?

Yes. Their market prices can decline because of interest-rate changes, company-specific problems, market conditions, liquidity issues, and other factors.

5. Can preferred stocks be converted into common stocks?

Some preferred stocks are convertible. Convertible preferred shares allow conversion into common shares according to specified terms.

6. Do preferred shareholders have voting rights?

Often they have limited voting rights compared with common shareholders, but the exact rights depend on the preferred stock’s terms.

7. Are preferred stocks debt or equity?

Preferred stocks are generally classified as equity because they represent an ownership interest in a company. However, they can have income characteristics that resemble debt.

8. What is the biggest advantage of preferred stocks?

A major advantage is the priority generally given to preferred shareholders over common shareholders for dividends and liquidation proceeds, along with the potential for regular dividend income.

Conclusion

Preferred stocks occupy an important position between common stocks and debt securities. They represent ownership in a company while often providing investors with priority for dividends and liquidation proceeds over common shareholders. Their main attraction is typically income. Many preferred shares have predetermined dividend terms, while some also offer features such as cumulative dividends, conversion rights, or redemption provisions.

However, preferred stocks also carry meaningful risks. Their prices can decline when interest rates rise, the issuing company can experience financial problems, dividends can be affected according to the security’s terms, and callable shares may be redeemed by the issuer. The key lesson is that preferred stocks should be evaluated based on their individual terms rather than simply their dividend yield. Understanding the dividend structure, liquidation preference, call provisions, conversion features, credit quality, and market risks can help investors make more informed decisions.

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