How Does Preferred Stock Work?

Within the vast spectrum of financial instruments, preferred stocks (or "preferreds") occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments.

Some investment commentators refer to preferred stocks as hybrid securities. In this article, we provide a thorough overview of preferred shares and compare them to some better-known investment vehicles.

A company may choose to issue preferreds for a couple of reasons:

• Flexibility of payments: Preferred dividends may be suspended in case of corporate cash problems.
• Easier to market: The majority of preferred stock is bought and held by institutional investors, which may make it easier to market at the initial public offering.

Institutions tend to invest in preferred stock because IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.

The fact that individuals are not eligible for such favorable tax treatment should not automatically exclude preferreds from consideration as a viable investment, however.

Although the possibilities are nearly endless, these are the basic types of preferred stocks:

• Cumulative: Most preferred stock is cumulative, meaning that if the company withholds part, or all, of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative, preferred.
• Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus.
• Convertible: The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus.
• Participating: Preferred stock has a fixed dividend rate. If the company issues participating preferreds, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating.
• Adjustable-Rate Preferred Stock (ARPS): These relatively recent additions to the spectrum pay dividends based on several factors stipulated by the company. Dividends for ARPS are keyed to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets.

Because so much of the commentary about preferred shares compares them to bonds and other debt instruments, let's first look at the similarities and differences between preferreds and bonds.

Similarities

Interest Rate Sensitivity
Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par, usually at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares falls. If rates decline, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds.

Callability
Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls in securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability.

Senior Securities
Like bonds, preferreds are senior to common stock. However, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much.

Convertibility
As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock. (For more, see "Understanding Convertible Preferred Shares" and "An Introduction to Convertible Bonds.")

Ratings
Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. (For more, see "What Is a Corporate Credit Rating?")

Differences

Type of Security
As observed earlier, preferred stock is equity; bonds are debt. Most debt instruments, along with most creditors, are senior to any equity.

Payments
Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends; the trust indenture prevents companies from taking the same action on their corporate bonds.

Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for a company to issue and pay dividends on preferred stocks. (For more, see "How and Why Do Companies Pay Dividends?")

Yields
Computing current yields on preferreds is similar to the calculation on bonds: the annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75 ÷ $25 = .07, or 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors.

Volatility
While preferreds are interest rate sensitive, they are not as price sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds.

Accessibility 
Information about a company's preferred shares is easier to obtain than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier, because bonds, with par values around $1,000, often have minimum purchase requirements.

Similarities

Payments
Both are equity instruments. Their dividends come from the company's after-tax profits, and are taxable to the shareholder (unless held in a tax-advantaged account).

Differences

Payments
Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied.

Appreciation
This is where preferreds lose their luster for many investors. If, for example, a pharmaceutical research company discovers an effective cure for the flu, its common stock will soar, while the preferreds might only increase by a few points. The lower volatility of preferred stocks may look attractive, but it cuts both ways: Preferreds aren't as sensitive to a company's losses, but they will not share in a company's success to the same degree as common stock.

Voting
Whereas common stock is often called voting equity, preferred stocks usually have no voting rights.

• Higher fixed-income payments than bonds or common stock
• Lower investment per share compared to bonds
• Priority over common stocks for dividend payments and liquidation proceeds
• Greater price stability than common stocks
• Greater liquidity than corporate bonds of similar quality

• Callability
• Lack of specific maturity date makes recovery of invested principal uncertain
• Limited appreciation potential
• Interest rate sensitivity
• Lack of voting rights

An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. The starting point for research on a specific preferred is the stock's prospectus, which you can often find online. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market.