Preferred Stock Explained

Everyone wants a high rate of return when it comes to investing.

So what’s considered a good rate of return?

Wait – are you sure that’s the right question to ask? Without a doubt, we can find decent returns in the stock market, but they come with considerable risk and volatility. We’ve worked hard for our money, and we don’t want to lose it with an ill-timed trade or a misjudged bet on the wrong company. ⚠

That said, the traditional safe harbors of bonds and Treasury bills can feel underwhelming. With inflation at its highest rate in 40 years and interest rates rising slowly, it doesn’t take much mental math to feel like our hard-earned investments are struggling to keep up.

If you’ve ever wished for another option, you may want to learn more about preferred stock. Preferred stock is a type of stock that shares characteristics with both bonds and common stocks, although with different trade-offs that an investor might expect. 

While preferred stocks typically offer higher dividends than we’d find with bonds or common stocks, those higher dividends aren’t necessarily guaranteed – depending on the type of preferred stock held. Furthermore, preferred stockholders don’t have as much protection as bondholders if a company crumbles, meaning that an interested investor still needs to carefully evaluate the company they are investing in. 🔍

Whether we are focused on generating income or simply just trying to beat the inflation rate, a preferred stock could benefit our portfolio. But, we need to be sure that we fully understand the risks and benefits of this lesser-known product.

Luckily, you’ve come to the right place. This guide covers the basics of preferred stock, a few different types of preferred stock available, and some of the common pitfalls that investors will want to avoid.

What is Preferred Stock? 📙

Preferred stock is a hybrid asset that offers investors more benefits than a common stock. For example, preferred stockholders are eligible for a set schedule of dividend payments and are paid back ahead of common stockholders in the event of liquidation. Common stocks, however, grant shareholders voting rights while preferred stocks do not.

Businesses sell ownership or equity in their companies through stocks, and in fact, there are a variety of different stocks. The most popular of which come in two forms: common stock and preferred stock.

Common stocks are typically what we think of when we think of the stock market – shares whose prices change by the minute based on what the market thinks the company is worth. Shares of a preferred stock are quite different, issued with a predetermined par value (face value) rather than a fluctuating market-driven price. 

And unlike other fixed-income securities such as bonds or Treasury bills, preferred stock doesn’t eliminate the potential for upward movement in gain. These characteristics can make preferred stocks attractive to risk-averse investors who want their investments to provide them with a stable cash flow.

Breakdown of How Preferred Stock Works 👷‍♂️

Like common stocks, shares of a preferred stock are purchased and traded through most popular online stock brokers. Although not every brokerage will offer the same access to preferred stocks, their offerings are available online to check before committing to an account.   

When considering what preferred stock to invest in, look at its par value and dividend schedule. For preference shares (a commonly used name for a share of a preferred stock), par values are typically $25 per share. This lower price point makes it easier for an individual investor to invest in well-known, larger companies whose common stock sells at a higher price. 💰

The dividend schedule is also important to examine so an investor knows the amount they will receive from the stock’s dividend payments, and whether dividends are paid out on a monthly or quarterly basis. Understanding a company’s dividend schedule can help investors find the right balance of assets in their portfolio to ensure that they receive income at regular intervals – if that is their goal. Typically, a preferred stock will offer higher dividends than a common stock, or the interest payments earned from a bond.

In case higher dividends and fixed payments aren’t enough motivation, preferred stock also offers stockholders enhanced protection in the event of bankruptcy. If a company fails, there is a defined order in which it must pay back all of its financial obligations. In these situations, the company in question must settle all debts before the company can begin compensating equity obligations – where preferred stockholders are paid before common stockholders.

This means that preferred stockholders are granted an extra layer of protection in the event of a catastrophe – a peace of mind that we won’t find investing in common stocks.

Who Purchases Preferred Stock? 🤔

The typical purchasers of preferred stock are not individual investors, but institutions. One reason for this is tax benefits – institutions are taxed at a lower rate for qualified dividends than they are for bond interest. 

This means that preferred stock gives companies a relatively safe place to invest their money while earning higher payments than a bond could offer, at a lower tax rate than a bond would require them to pay.

Unfortunately, this tax advantage isn’t available for individual investors, but there are still a few reasons why a retail investor would think about purchasing a preferred stock. For example, when interest rates are low, preferred stocks can be a safe way to generate higher dividend payments than a savings account or elsewhere in the fixed-income securities market. A preferred stock could also be a good choice for investors who prioritize a steady income stream.

Understanding Preferred Stock 👨‍🏫

When it comes to preferred stock, there are four main types of stock offerings: cumulative, non-cumulative, participating, and convertible. Understanding the differences between these types of preferred stock can help determine which type works best for your own needs and desires.

Cumulative Preferred Stock ☑

Cumulative preferred stock is a type of preferred stock that offers enhanced protection for a stockholder’s dividend payments, ensuring that cumulative preferred stockholders are paid their dividends ahead of any other type of stockholder. 

Dividend payments are, technically, optional and if a company is struggling or experiencing cash flow issues, it may choose to pause dividend payments until it can improve its financial situation. Cumulative preferred stock ensures that shareholders will eventually get paid all of their owed dividends, even if it isn’t on the original timetable.

These unpaid dividends are typically called dividends in arrears, meaning an overdue debt or outstanding financial obligation. If a company liquidates, the cumulative preferred stockholder would be eligible for the par value of their preferred shares and their dividend in arrears. Occasionally, interest is awarded to stockholders for late dividends, although this depends on the terms of each preferred stock.

Regardless of whether the dividends include interest payments, cumulative preferred stockholders are still granted special status over common stockholders and must be paid back first.

Non-Cumulative Preferred Stock ☑

Unlike cumulative preferred stock, non-cumulative stocks don’t offer the same dividend protection. If a company refuses to or cannot pay dividends in a given year, the investor doesn’t have any rights or power to claim these foregone dividends. 

To compensate for this increased risk, non-cumulative preferred stocks typically offer slightly higher dividends than one can find in a cumulative preferred stock. But, cumulative preferred stock offerings are far more common, so finding a non-cumulative preferred stock offering can be challenging.  

Although the nonpayment of dividends does happen, a company is incentivized to ensure that it doesn’t. A company that doesn’t pay shareholders their full dividends is unlikely to be an attractive stock for other investors in the future, which can seriously damage the company’s value.

Participating Preferred Stock ☑

Participating preferred stock is an interesting subtype of preferred stock that can offer investors extra dividends if the company is liquidated. If that occurs, participating preference stockholders have the right to be paid both the par value of their holdings and a proportional (commonly known as “pro-rata”) share of the remaining proceeds that the common stockholders would receive.

As a participating preferred stockholder, an investor receives all of the benefits of a preferred stock. They can still earn extra money if the company liquidates, as though they were common stockholders. While non-participating preferred stockholders are still entitled to the par value of their holdings, they aren’t privy to this extra share of the liquidation proceeds.

Convertible Preferred Stock ☑

Convertible preferred stock is a preferred stock offering where preferred shares can be exchanged for a fixed number of common shares after a specific date. This exchange occurs at a predetermined rate known as the conversion ratio.

The conversion ratio is set when the stock is issued, and spells out a single share of preferred stock is worth a set number of shares of common stock.

For example, let’s say a company issues convertible preferred shares to investors, with a par value of $200 per share, pays a 7.5% dividend annually, and has a conversion of 7.

If the company performs well and their common stock prices rise, investors can exchange their convertible shares and receive 7 common shares for every convertible preferred share they own. 

For the investor to make money on this exchange, the common shares must trade at a price greater than the initial purchase price of the preference share divided by the conversion ratio. In this example, the common stock would have to be trading higher than $200/7, which equals $28.57 per share, in order for the conversion to be profitable.

Typically, investors can exchange convertible preferred stock for common stock after a particular time – say, five years after the issue date. These conversions are usually done at the shareholder’s request, although sometimes companies will include a condition allowing them to coerce investors to convert their stock holdings into common stock.

A convertible preferred stock can be an exciting opportunity for investors because of the potential to reap great gains should the company explode in value. Say we invest in an upcoming startup that goes on to be the next Meta or Google – the returns would be astronomical. Moreover, the ability to convert shares to common stock makes the value of this type of preferred stock much more closely tied to the company’s overall market performance.

Why Do Corporations Issue Preferred Stock?

There are many reasons why a company would choose to issue a preferred stock over a bond or common stock. For starters, issuing a preferred stock can be a simple way to raise capital to finance a new project or help the company grow. 📈

Given that institutions are the typical buyers of preferred stock, and they tend to buy in bulk, a company can sell a large volume of preference shares faster and easier than an equal amount of common stock to many individual investors.

A company may also choose to issue preferred stock if financial regulations prevent them from taking on more debt. This is particularly true for financial institutions, whose debt levels are highly regulated and thus may have to look for other means of raising capital for new projects.  

While bonds are classified as a debt liability, preferred stock is considered an equity asset. This seemingly trivial distinction matters because of a measure called the debt to equity (D/E) ratio. For investors and analysts, a company’s debt to equity ratio can signify a healthy or hurting company and can drive investors either towards or away from its stock. 👨‍💻

The higher a company’s debt to equity ratio, the higher its chances of being considered a risky investment; making it less attractive to investors. When considering preferred stock, investors should ask why a company chooses to offer this particular asset, and not a bond or common stock.

In theory, any company could issue preferred stock, but the most common issuers are financial institutions in practice. In addition, many telecommunications providers (e.g. AT & T Inc.) , transportation companies (e.g. Costamare Inc.) , and utility companies also issue preferred stock.

The businesses that offer preferred stock tend to fall into either the upper or lower bounds of creditworthiness – in terms of company health. While that can feel intimidating, we have to do our homework and not take on any more risks than we are willing to accept.  

For some investors, it may inspire them to look at a preferred stock mutual fund or exchange-traded fund (ETF) rather than take the riskier path of investing in a single company.

Things to Know Before Buying Preferred Stock 📝

As an individual investor, there are a few simple questions that one should ask before clicking “Buy” on any preferred stocks. To begin with, is the stock cumulative?  

Cumulative preferred stock guarantees that the investor will eventually receive all of the dividends to which they are entitled. If the stock is a non-cumulative preferred stock, does the company have any history of not paying dividends?

Another point to consider is whether the stock is convertible. If so, find out who is eligible to initiate the conversion of said stock and at what conversion rate. As individual investors, we may want the flexibility to convert our holdings to common stocks if the market conditions are right. But likewise, it is important to know if a company can compel us to convert our stocks, mainly if they are part of a plan for monthly income.

A final point to think about is the overall health of the company. Although preferred stockholders are offered enhanced protection compared to common stockholders, it is important to examine any company’s motivation for offering preferred stock. For example, does the company have a higher, less-attractive debt to equity ratio? Are there any red flags in their past that might suggest that this is a riskier investment than we are willing to make?

Common Stock vs. Preferred Stock ⚖

Although common stock and preferred stock share some characteristics, they also hold key differences. For instance, holding common stock confers voting rights to the stockholder, while preferred stock doesn’t bestow those same rights. As investors, we have to decide if a role in corporate governance is something that we value and prioritize.

Another significant distinction between common stock and preferred stock is the opportunity for financial upside. Common stock offers the potential for significant financial gain, but it does so with far greater risk. Meanwhile, a preferred stock provides relatively safe and regular payments but is unlikely to result in sky-high levels of return.

Preferred stock is also unique in its callability – the ability to be forcibly repurchased by the issuing company. Investors will still receive the par value of their holdings if a company decides on a share callback – but it can throw a wrench into our carefully laid plans. For instance, an unexpected callback could be problematic if an investor purchased a preferred stock on the secondary market for a higher price than the par value.  

Although common stock and preferred stock vary in important ways, they share ease of commerce that isn’t available with bonds or other fixed-income securities. Preferred stock can be bought and sold on the secondary market, just like common stock. This allows the average investor to easily dip their toes into the preferred stock pool without the hassle and commitment of creating new accounts just to trade one specific asset.

Conversion Ratio for Preferred Stocks 📜

The most critical number to know for convertible stock is the conversion ratio or the number of shares of common stock that a single share of preferred stock can be exchanged for. Like in our earlier example, a conversion ratio of seven would mean that a single share of preferred stock can be traded for seven shares of common stock.

Although being able to exchange our preferred stock may be beneficial, it is worth doing some quick math to make sure that the trade benefits our bottom line. For example, if we bought $100 worth of preferred stock from Wayne Enterprises (WE/BAT). If the given conversion rate is four, for each share of WE/BAT preferred stock we exchange, we would get four shares of common stock.  

Dividing the $100 value of our preferred stock by our conversion rate of four generates a conversion price of $25. If Wayne Enterprises’ common stock is trading at $10/share, we will lose money converting our holdings. But if the WE/BAT common stock is trading at $50 per share? Those shares are now worth a tidy profit, helpful if we need to free up some cash.

Bonds vs. Preferred Stock ⚔

Although it may feel counterintuitive, preferred stock and bonds share similarities. Both investments offer consistent, regular payments of either dividends or interest. Like bonds, preferred stock is issued with a predetermined value that doesn’t change during the lifespan of the stock.  

But, investors must remember that while bonds are considered debt, a preferred stock counts as equity. If a company is liquidated, this is a crucial distinction in terms of repayment order. In the worst-case scenario where a company goes belly up, bondholders will get paid back before preferred stockholders.

On top of that, we must keep in mind that dividends are not guaranteed to arrive on schedule. Sometimes, they may not arrive at all. To suspend dividend payments only takes a vote by the company’s board, rather than the far more serious default that the nonpayment of bonds demands.  

As a final point, the ability for shares to be repurchased or called by the company is unique to preferred stock. Bondholders are entitled to their bonds for the predetermined length of the bond. These terms are regardless of any change in market conditions or company health.

Preferred Stock Example 📚

A well-known company that regularly offers preferred stock is Bank of America. In January 2022, the Bank of America issued a preferred stock with an annual dividend rate of 4.750%. The preferred stock exists in perpetuity, meaning that there is no endpoint or maturation date, as a bond would have.  

Shares were sold for $25 per share, an easy entry point for an individual investor. If an investor were to invest $100 into a preferred stock with these terms, they would hypothetically earn $4.75 per year in dividend payments.  

However, it is worth pointing out that in this example, the preferred stock is non-cumulative, meaning that the investor has no guarantee of dividend payments. Bank of America also includes a callable date in February 2027, meaning that the company would have the right to “callback” their shares after that date if they so choose.

Pros and Cons of Preferred Stocks 🌟

For any investment strategy, it is essential to weigh the pros and cons to determine each offering’s value proposition for your unique financial situation. A preferred stock can be attractive because of its fixed higher dividends and relatively secure position in the line of succession. On the other hand, finding a reputable company offering participating or convertible shares and a preferred stock can seem better.

But, preferred stocks do have unique stipulations that require an investor to do their homework. For example, preference shares can be called or forcibly converted, potentially forcing an investor to redesign their income-generating strategy. And while some types of preferred stock allow the investor to reap the windfalls of a common stock price surge, preferred stockholders don’t necessarily share in the equity appreciation generated by the business.  

That said, preferred stocks offer some limited upward potential, unlike a bond or a Treasury bill, where investors know the exact amount of money they will receive. Moreover, since 1900, preferred stocks have seen an average annual return of over 7%, a decent record for a lower-risk investment.

However, investing in a single individual company is always a risk. Although preferred stock mutual funds and exchange-traded funds exist, an investor still needs to examine the details of those funds and how they handle situations like a coerced share call or conversion.

Overall, preferred stock can provide investors with peace of mind, given the relatively low risk of the product and the predictable income it offers. In addition, just like bonds, preferred stocks are rated by the major credit agencies, making it far easier to determine whether an individual stock presents more risk than we are willing to bear.  

Conclusion 🏁

As investors, we are all looking for that perfect balance of a safe investment with high returns. A preferred stock can be a viable option in pursuit of that goal. 

Looking at the available offerings on different brokerage platforms may help investors discover the right preferred stock to help diversify their retirement portfolio or protect their investments from inflation.

Get Started with a Stock Broker