Preferred Stock: What It Is & How It Works (2024)

What Is a Preferred Stock?

A preferred stock is a share of ownership in a company, but it differs from what one typically things of as a share, called a common share, as it grants some enhanced characteristics or benefits. For example, if a company can't afford to pay preferred shareholders a dividend, then common shareholders definitely won't receive one. However, preferreds usually do not give holders the right to vote on the company's future, while common shares do.

How Do Preferred Stocks Work?

Preferred stocks generally combine certain characteristics of bonds and common stock. Similar to bonds, preferred shares usually pay dividends, but they usually don't come with voting rights.

If a company faces financial difficulties, it may not be able to pay its dividends to preferred shareholders. Should dividends be suspended for a period of time, preferred dividends must resume before any dividends for common shareholders. Unlike bonds, companies that go into arrears with the dividend payments on their preferred shares are not considered to be defaulting.

Dividends can be paid quarterly or monthly and can be fixed or adjustable according to a benchmark interest rate like the federal funds rate. They are usually paid quarterly and set as a fixed dollar amount. In most cases, dividends are cited as a percentage of par value in the description of the shares on the company's financial pages. The dividend dollar amount generally stays the same, although the market yield changes as the market value of the preferred share changes. Adjustable-rate preferreds list a number of factors that affect the dividend yield.

In the hierarchy of assets owned, a company's preferred shares are ranked higher than its common shares but lower than its bonds. That means bondholders are paid before preferred shareholders in the event of a liquidation, while preferred shareholders are paid before common shareholders.

Key Takeaway: Preferred stocks are a sort of hybrid asset, offering some characteristics of bonds and some of common stock.

Why Invest In Preferred Stock

There are many benefits to investing in preferred stocks, including:

• Higher dividends: Investors who want a steady income from their investments may appreciate the usually higher dividend paid on preferreds.
• Give investors the right to be paid before common shareholders if the company ever goes bankrupt.
• Less volatile than common shares
• Could receive more than par value when a company calls its preferred shares in: Sometimes when a company calls in its preferred shares, it will pay more than par value, so preferred shareholders could receive more than what they paid for the stock.
• Can be converted to common shares: Preferred shares can be converted to common stock in some circ*mstances. It might make sense to convert shares if the price of the common stock increases significantly. When a convertible, investors can look at the conversion ratio to see how many common shares they will receive for each preferred share. For example, they might receive five common shares for every preferred share converted.
• Converting allows the investor to participate in any potential upside of the common stock: Although preferred shares with no conversion option would not benefit from common stock price upside.

Tip: Preferred stock usually offers higher dividends than common stock, so they can be a good source of steady income as long as the company continues to pay.

There are also major risks and potential downsides to preferred shares, including:

• Generally sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares may drop.
• No guarantee that they will pay any dividends, even if they state that they will. If companies are unable to pay their dividends on their preferred shares, they are not in default, which means shareholders cannot sue to receive their payments, like bondholders can.
• There is always a risk that the company will have to liquidate, as is the case with all stocks. Preferred shareholders must wait until all the company's creditors are paid before they can have any potential claim on its assets.
• Some come with call provision, which means the issuing company has the option to redeem the shares whenever it wants to. The risk of a company calling in its preferred shares increases when interest rates drop.

A company could call in its preferred stock to reduce its expenses by redeeming it at par value, which is the amount the company uses to calculate the dividend. Par value isn't the same as the market value the preferred shares are trading at. Not all preferred shares come with a call option.

After redeeming preferred stock that pays the higher dividend, the company could then reissue preferred shares with a lower dividend based on the lower interest rate. In such a situation, investors would lose the potential capital gains from rising market prices, and if they reinvest in the new issue, they may have to do so at a lower interest rate.

Common vs. Preferred Stock

When comparing common vs. preferred stock, there are some things to keep in mind.

1. Common shares usually come with voting rights, while preferred shares usually don't.
2. Companies are more likely to pay dividends on their preferred shares than on common shares. Smaller companies in development stage are less likely to pay common stock dividends, but if these firms issue preferreds, dividends will usually be declared and paid on the preferred stock.
3. Not all public companies issue preferred shares, while all do provide common stock.
4. Preferred stocks generally have less opportunity for price appreciation, though if the preferred shares are convertible, they may rise significantly in price if the common shares are moving higher.
5. Investors have the option of converting preferred shares into common shares to take advantage of any price appreciation. At that point, however, the investor has relinquished the stability of preferred shares, and becomes fully exposed to the common stock
6. Preferred shares may have a call option, while common shares don't, although a company can choose to buy back some of its common shares to return capital to shareholders. When a company calls in its preferred shares, it may pay par value or a little more than par value. That could end up being more or less than what investors paid to purchase the shares.

How To Buy Preferred Stock

Investors can buy preferred stock the same way they buy common stock. Preferred shares trade on stock exchanges and can be purchased via an online brokerage that offers them. Not all online brokerages offer preferred stock. Investors should also note that the ticker symbol for preferred stock is different than the symbol used for companies' common stock.

When buying preferred stock, investors might want to look at the following and factor those numbers into the decision of whether to buy.

• The company's credit rating with Moody's or S&P
• The dividend yield on the shares

The better the credit rating, the more likely the company will be able to continue paying its promised dividends on its preferred stock.

Not all companies issue preferred stock, and some that do may offer more than one issue. For example, companies offering multiple preferred stocks might issue them with different dividend yields.

Funds Focused On Preferred Stock

If investors want access to a portfolio of preferred shares but don't want to buy them individually, they can also buy an exchange-traded fund or mutual fund that focuses on preferred stock. Like stocks, ETFs and mutual funds are traded on exchanges via online brokerages.

Examples of ETFs that focus on preferred shares:

• iShares Preferred & Income ETF (PFF)
• Invesco Preferred ETF (PGX)

It might be easier to purchase an ETF or mutual fund because some online brokerages that don't offer individual preferred stocks might still offer funds focused on preferreds.

Examples of mutual funds that invest in preferred shares:

• PIMCO Preferred and Capital Secs Fund (PFANX)
• Principal Capital Securities Fund (PCSFX)

Should You Invest In Preferred Stocks?

For unclear reasons, most buyers of preferred stocks are institutional investors, but that doesn't mean individual investors can't buy them. If you buy preferred shares that offer a dividend, they could offer a steady income stream for your portfolio.

Preferred stock usually offers higher dividends than common stock and bonds issued by the same company. Additionally, preferred stock is often less volatile than common stock, so it can be less risky.

On the other hand, if you want to have a say about the future of the company through voting rights, investors will have to consider common shares. Preferred shares don't usually come with voting rights.

Additionally, while investors may want the steady payments preferred stocks usually offer, they are riskier than bonds, so if you are especially risk-averse, you might want to buy the company's bonds instead.

As with every investment, investors are encouraged to do due diligence before investing. For preferred share issues, in addition to assessing the dividend yield, it's a good idea to check the credit rating and standing of the issuing company.