What Is Preferred Stock? Key Features, Types, and Investor Advantages

TradingKey - Have you been searching for an investment alternative to common stocks that will yield consistent dividend payments and a lower degree of volatility than common stocks? Consider investing in preferred stock.

This guide covers everything about preferred stock, from its definition to who typically purchases this type of security. Learn about the different types of preferred stock available to investors. Understand how preferred stock is a hybrid investment type that combines both bond-like and stock-like characteristics, so you can make an informed decision about whether or not it is suitable for your portfolio.

Publicly traded corporations offer two different classes of equities: common shares and preferred shares. 

Preferred shareholders are entitled to receive dividends at an earlier stage than common shareholders, as well as receive their proportionate share of the corporation's assets before common shareholders receive any of the corporation's assets in the event of liquidation or reorganization. 

Preferred shareholders will normally not have any voting rights associated with their preferences. The exact benefits, distributions, and protection available to preferred shareholders are contingent on the specific terms of the individual issues of preferred shares.

Preferred shareholders are entitled to receive dividends before common shareholders do (although there are exceptions) and generally receive dividends either monthly or every three months. Dividends may be set at a specific amount or based on an interest rate benchmark like SOFR (secured overnight financing rate). Additionally, when a preferred stock security is issued, the dividend payout is usually quoted as a percentage. Preferred stocks also typically are available with variable interest rates based on a predetermined metric that directly affects the dividend yield (also known as the dividend yield ratio) and so-called "participating preferred" that entitles shareholders to receive additional dividends based on the common stock's dividends or company profits, if any, beyond fixed dividend amounts. A company's board of directors determines whether to pay dividends.

Preferred shareholders have fewer rights than common shareholders as far as voting is concerned. A preferred stock is a combination of characteristics from both debt security (because they usually require fixed periodic interest payments) and equity security (because the owner has rights of ownership and potential appreciation). This, in effect, creates an instrument that provides investors with an avenue to invest in an equity-type investment while also providing greater predictability for future cash flows.

There are many different kinds of preferred stock, and every issuance has its own unique features that affect the attractiveness of each of these various issuances compared to the other issuances.

• Prior Preferred Stock

The term "prior preferred" describes a previously issued preferred stock that is at the top of the preference order among preferred tiers. While both prior preferred stock and standard preferred stock are higher in the capital structure than common stock, if a company can pay dividends on only one tier of preferred stock, the company will be required to pay dividends on the prior preferred stock first. This hierarchy governs the decisions regarding dividends and the hierarchy of creditors with respect to different levels of preferred stock.

• Preference Preferred Stock

Preferred stock refers to the second level of priority after prior preferred stock has been issued. While preference preferred stock is often in a higher priority position compared to any other preferred stock that has not been issued as a prior preferred stock, the order in which the various tiers of preferred stock are paid should be defined and specified (e.g., most senior, second most senior) in terms of the order in which they are to be paid.

• Perpetual Preferred Stock

Other types of preferred stock will have an expiration date, which is the date on which the company's capital will be returned (similar to the way a bond is redeemed at maturity). However, most preferred stock has no fixed date for when the investors will receive their original capital back, and thus it is referred to as perpetual. Investors who want out must sell their shares in the market to realize their investment.

• Convertible Preferred Stocks

Convertible preferred stock allows an investor to convert the preferred shares into a predetermined number of common shares as specified in the prospectus. The investor can either convert the shares anytime, regardless of stock prices for either class, or have conversions triggered by specified events (e.g., common or preferred stock trades above a certain price for a certain period of time). Once the conversion occurs, the transaction is irreversible, and the holder cannot return to preferred stock.

The number of common shares received per convertible preferred share is established in advance so investors know what their conversion entitles them to.

• Cumulative Preferred Stocks

Cumulative preferred stock accumulates unpaid declared dividends, with a requirement that those dividends will be paid in the future. Since preferred stock ranks ahead of common stock for dividend payments, all cumulative preferred stockholders must receive the total of all accumulated dividend payments on their cumulative preferred stock before any common stockholders receive any dividend payments.

• Noncumulative Preferred Stocks

Noncumulative preferred stock does not allow for the accumulation of unpaid declared dividends. If a dividend payment is not made during the year, the nonpayment does not affect any future rights of noncumulative preferred stockholders and does not create an obligation for the company to pay that dividend payment at a later time. Regulators classify this type of structure because the structure is typically found within the banking industry and is subject to international capital rules that dictate how these structures are classified.

• Participating Preferred Stock

Even if a company doesn't pay out regular dividends to its participating preferred shareholders, there is still the opportunity for them to receive additional dividends during periods when there are high levels of profitability from their business. The additional dividends can be calculated based on different criteria (metrics), such as company revenue, net income, and profit margins, and provide the opportunity for shareholders to collect these dividends in addition to the normal preferred stock dividends once the company has the resources available to support them. 

Preferred stockholders typically do not have the right to vote on corporate matters, although some issuers offer the option to reinstate voting rights if a shareholder has not received dividends for a specific time frame. 

Price movement for preferred stocks has historically been more stable and consistent than the common stocks issued by the same issuer because of this situation.  In many cases, preferred stocks will maintain their price ranges within a few points of their initial sale price (usually 25 dollars). 

The premium or discount pricing for preferred stock is dependent upon the creditworthiness of the issuer, the structure of the individual preferred stocks (including whether the dividends will be cumulative), the position of the preferred stock relative to the other classes of preferred stock, and whether the issuer has the option to call back the stock at a predetermined price. 

A callable issue allows the company the option to reacquire the stock at face value by a certain date. In times of falling interest rates, many companies may choose to call and refinance by issuing new preferred shares that have lower dividend rates, which will ultimately lower the company's cost of capital. After the call date, preferred shares may continue to trade on the secondary market until either the issuer decides to call or redeem them, or unit prices reflect the market's perception (or lack thereof) that this will occur.

Many companies also issue convertible preferreds, which provide profitable options for shareholders through an exchange of convertible preferreds for a predefined number of common shares at designated times. The board of directors may vote to initiate the conversion, the holder may be able to initiate conversion, or the security may convert automatically after an established date. When last priced, whether conversion is advantageous to a shareholder depends on the then-current price of common shares.

Preferred stock is one type of equity issued by corporations that provides its shareholders with different rights than those given to the holders of common stock (i.e., common shares). These rights typically provide preferred shareholders with higher dividends, as well as a greater priority over other classes of equity in the event of liquidation. 

Many preferred stocks contain a callable feature allowing the issuer to call (repay) the preferred shares at a specified price and on a specified date based on the information provided in the respective prospectus. Preferred stock combines the characteristics of owning equity in a corporation with the characteristics of holding a bond; therefore, preferred stock is often referred to as a hybrid security.

With increased privileges and priority on dividends, preferred stock comes with its trade-offs. Preferred stock also generally does not appreciate in value as much as common stock during bull markets. Additionally, preferred stockholders possess very little or no influence in any decision-making of the corporation, because they typically do not have voting rights.

Preferred stock is frequently compared to bonds because both provide investors with regular cash payments, and both generally have a par value assigned that determines future payments regardless of the price at which they are traded on the market. Investors in preferred stock receive ongoing income through dividends, similar to how investors in bonds receive payments from the bonds' coupon rates.

There are significant differences between the two. 

First, the board of directors has the authority to discontinue or alter the payment of dividends on preferred stock, whereas bond investors are assured that their interest payments will remain fixed until the bonds mature.

Second, preferred stock dividends generally receive a lower tax rate than do the interest payments received from bonds

Third, when bonds mature, bondholders receive their invested principal back from the issuer, while most types of preferred stocks do not have a specific maturity date and are therefore deemed to be perpetual unless a company's existence is terminated. 

Finally, in the event of a company being liquidated, any remaining assets will be distributed to the bondholders first before any payouts can be made to the holders of preferred stock, who are usually in a senior position to the common equity holders. Because the creditors have a higher claim than the preferred equity holders, rating agencies tend to provide a lower rating for preferred equity than for an issuer's bond, which results in a higher yield for investors in preferred equities to compensate for the risk associated therewith.

A variety of terms are available when issuing preferred stock, and most retail investors are able to purchase these shares from their online brokerage accounts. The terms and features discussed here represent only a small portion of the total types of preferred shares available to investors. 

It is common for issuers to combine various types of preferred stock in packages. Preferred shares may be created using any of a number of different structures, as long as they are compliant with the applicable federal regulations governing their issuance. While most issues do not contain a maturity date, many preferred shares do contain a date in the distant future.

Institutional investors tend to be the biggest purchasers of preferred shares, particularly during the initial distribution phase, due in large part to the tax benefits that retail investors do not receive. 

The ability of these large purchasers to deploy a large amount of capital at one time makes it a highly attractive and efficient means for firms to raise capital from an institutional investor perspective. Many companies, especially private or pre-public companies that wish to raise capital, also use preferred shares to raise funds. 

Issuers of preferred shares generally sit on both ends of the credit spectrum; many smaller firms choose to issue preferred shares because they cannot take on any more debt due to regulation, while larger established companies like General Electric, Bank of America, and Georgia Power are able to issue preferred shares to finance their business operations.

Preferred stock provides investors desiring an equity investment along with stability, cash flow and dividend tax benefits with an investment choice. 

Preferred shareholders may have tax advantages on dividends paid to them. Although corporations issuing preferred stock do not receive any tax benefit on the issuance of preferred dividends, large institutional investors or large corporations may be interested in investing in preferred stock due to the tax treatment of the payment of such dividends as well.

Preferred stock is classified as an equity investment and therefore contains the same types of risk as common equity, including the potential for a complete loss of principal. 

Although preferred and common stock have different attributes and may perform differently, the value of both is dependent on the underlying company's financial viability.

If business conditions weaken, the market value of preferred stock may also decline because of pressure from lower business valuations.

For equity investors seeking to earn cash flow, preferred stock may be an optimal alternative to common equity. It indicates ownership in an entity and has precedence for dividend payments. The potential drawbacks exist; however, preferred shares provide an alternative means of investment that will provide income and more consistent stability regarding potential future cash flow while still providing some level of equity market risk.