Preferred stocks have some qualities of common stocks and of bonds. The price of stock is variable to the profitability of the company, whereas bonds prices vary with the company’s ability to pay. Preferred stocks, similar to bonds, pay an agreed upon dividend at regular intervals.
Common stocks may pay dividends, but it is dependent on how the company is doing. Preferred stocks are called so because they give owners a priority claim when a company pays dividends or distributes assets to its shareholders. They also do not usually have voting rights in company decisions.
Basics Of Preferred Stock
In order to understand what a preferred stock is, we must first understand what in general a stock is. From there we can review how a it works, the different types, the different dividend structures as well as the potential advantages and disadvantages.
What Is A Stock?
Stocks are a type of security that provides the stockholders with an ownership share of a company. People buy stocks in the hopes of making money, either with a short term or long term scope, or to have a vote to influence a company.
Companies issue stock in order to try to get money in order to launch new products, expand regionally or globally, pay down debts, or to update existing facilities and/or build new ones.
How Preferred Stock Works
Preferred stock is a sort of hybrid security that has the features of both common stocks as well as bonds. This stock combines equity ownership advantages of common stocks, as well as the steady, consistent income payments of bonds.
The preferred stock has potential for the shares to rise in value over time, in addition to paying dividends regularly. There is also an ability to convert from preferred stock to common stock. You can trade in your preferred stock for common stock when you buy convertible shares.
Different Types Of Preferred Stocks
In general there are a couple different types of preferred stocks. Preferred stocks may fall into one of the following categories or more:
- Cumulative preferred stock: These pay a fixed dividend at regularly scheduled intervals. Usually this occurs quarterly. If the dividend is not paid, the unpaid dividend amount accumulates and has to be paid out before common stockholders are issued dividends
- Participating preferred stock: This type issues a special dividend if certain financial goals are met by the company. An example of this would be if the common stock share price meets a particular predetermined level
- Callable preferred stock: As its name implies, these are callable back to the company at a future date based on the issuer’s discretion. This would be done at the redemption level price. That price may be the original issued price, or slightly higher to return investors a profit
- Adjustable-Rate preferred stock: This type varies its dividends based on a specified benchmark, which is usually the T-bill rate. The dividend value varies a predetermined formula to move with the interest rates in the adjustable-rate preferred stocks, leading them to be more aligned with inflation than fixed-rate preferred stocks
- Convertible preferred stock: These give stockholders the ability to convert preferred shares to common stock in the same company. These stockholders can sometimes convert stock at a discount, thus trading in their preferred shares for the company’s more liquid common shares
Preferred Stock Dividends
The terms of preferred shareholder’s economic preference may vary from one company to another. They may be distributed Non-Cumulatively or Cumulatively:
- Non-Cumulative: Sometimes the preference may state that cash available for distribution during the year must be used to meet promised payments to the preferred shareholders (before any of the common stock dividends are able to be paid)
- Cumulative: Other times the preference is cumulatively applied. Any payments that were missed to preferred shareholders have to be paid prior to the common shareholders receiving anything
- Preferred Stock Dividend Yields: Preferred stock dividend yields are more static than common stock dividend yields. Common dividend yields tend to be more variable
It is important to note that Preferred shares offer more dividend security than Common stocks. However, you are not guaranteed to receive dividends.
Benefits Of Preferred Stocks
Preferred stocks offer a few advantages over the common stock. Some of these unique benefits are as follows:
- Higher dividends: You can receive higher dividends with preferred shares as opposed to common shares. Since there is more risk involved in stocks in general, your payouts would be higher than what you would typically receive with a bond for instance
- Priority Over Common Shareholders: Preferred shareholders are above Common shareholders on the totem pole. If something were to happen to the company and they go bankrupt, they take priority. (Note: bondholders still have highest priority, but preferred shareholders follow afterwards)
- Callable Share Premium: Preferred stocks are callable. This means that a company is able to buy it back if they so choose. If the callable price is above the value you paid, you would have made an immediate profit.
Risks Of Preferred Stocks
There is definitely some risk associated with preferred stocks. Some of the risk may be inherent to stocks in general, others are more specific to preferred stocks.
- Market Fluctuation: They fluctuate with the stock market. This can include it’s wild swings in either the positive or negative direction
- Stock Callback: With preferred stocks, a company may call back the stock with little notice. It may not even be any notice at all. In addition to pulling or calling back the stock
- Debt Priority: Any unpaid preferred stock dividends would rank below obligations to creditors during bankruptcy or liquidation
Consider Guidance From A Financial Advisor
Preferred stocks provide you with a few advantages over common stocks. You have a higher priority when it comes to dividends and asset payout if issues arise in the company. It does however come with some risks associated. For example, if a company decides to call back its stock or goes bankrupt. If you have any other questions, or need some more information regarding preferred stocks, you should contact a financial advisor near you.