Companies that wish to raise capital by issuing stock have two basic options available to them. They can issue common stock, which is by far the more, ahem, common form of stock that is traded, or they can issue preferred shares, which share some characteristics with their common cousins but differ significantly in several respects. Although preferred shares still technically represent shares of ownership in a company, these somewhat unique instruments behave more like fixed-income securities than common stock.
Preferred stock is generally considered a hybrid security by definition. Although it is issued in shares like common stock through an initial public offering, it typically trades at a relatively stable price. Preferred shares are usually issued at a par value of $25 and will often only rise or fall by a dollar or two in price during their lifetime. Most preferred shares pay interest or dividends on a quarterly or semiannual basis, and this income is usually what makes them attractive to investors. These shares also resemble bonds in some respects, as their prices tend to rise and fall inversely with interest rates. They are usually issued with a stated coupon rate and also mature at a specific date in some cases. Many preferred shares also contain call or put features or other characteristics that are traditionally associated with bonds. They also differ from common stock in that they have no voting rights; whereas common stockholders get one vote in corporate governance for every share that they own, preferred shareholders have no say in how the company is run. However, preferred stock gets its name from the fact that the issuing company will total up and pay its investors their collective dividends before doing so for the common stockholders. These stocks essentially receive preferential treatment in their dividend payments relative to common shares.
There is also a type of preferred stock that can be converted into a preset number of shares of common stock if the investor so desires. This type of convertible preferred security can provide the investor with the means to profit from capital gains at some point if the common stock price rises substantially. Obviously, the value of these securities will go up with the price of the common shares if this happens. Another type of preferred stock that has been around since 1993 is known as a hybrid preferred, which pays interest instead of dividends. This type of preferred is senior to other types of preferred stock in the liquidation process and also usually pays a slightly higher rate than other types of preferreds. These issues are identified using the appropriate acronym, such as QUID (quarterly income debt security) or QUIP (quarterly income preferred securities).
There are no special tax rules that apply to preferred shares; their interest or dividends are now always taxed as ordinary income (since qualified dividends have been discontinued by the IRS) and any profit or loss that is realized upon their call or sale is taxed as a long or short-term gain or loss accordingly.
Pros and Cons
Preferred shares offer two primary advantages for investors. The most relevant feature that most shareholders find appealing is their regular dividend payments, which typically provide a yield that is a percent or two higher than guaranteed instruments like CDs or treasury securities and is also usually superior to the dividends paid to common shareholders. Preferred stocks have historically provided competitive dividend income with minimal price volatility and almost total liquidity, as most shares are available to be purchased and sold at any time during intraday trading when the markets are open. Furthermore, the dividends of most preferred shares are guaranteed by the company, which means that if they are unable to pay a dividend for one or more periods, then they are required to make up for all past due payments when they become able. Common stock dividends are paid on a periodic basis solely at the discretion of the company’s board of directors. Owners of common shares of companies that do not pay stated dividends are often out of luck.
Preferred shares are also referred to as such because their shareholders will receive their money from the corporation before the common stockholders will if the company is ever liquidated. If the issuing company goes belly up, then preferred shareholders thus have less risk of losing their principal than common stockholders. But preferred stock is still theoretically subject to risk of default in the same manner as other types of fixed-income securities.
Although preferred shares offer many advantages, their biggest limitation is simply that they typically appreciate very little in price over time. While common shareholders may get a smaller dividend, this is often more than offset by long-term capital growth that can easily result in a substantially higher total return than what will be posted by their preferred counterparts. And the dividend rate for a preferred issue is usually permanent, which means that preferred shareholders of companies whose cash flows and balance sheets improve over time will not receive higher dividend payments that will likely be paid to common shareholders. (One exception to this comes with participating preferred shares, which do allow the company to pay additional dividends at its discretion during times of prosperity.)
The Bottom Line
Preferred stock can provide investors who seek stable income with a competitive dividend yield while maintaining a stable share price. Many preferred shares also come with additional features that can make them more (or less) attractive to investors depending upon the current interest rate environment. For more information on preferred stock and how it can fit into your portfolio, consult your stockbroker or financial advisor.