What is preferred stock, and who should buy it?

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Preferred stock is a type of stock that has characteristics of both stocks and bonds. Like bonds, preferred shares make cash payouts, often at a higher yield than bonds, while offering higher dividend returns and less risk than common stock.

The features of preferred stock provide investors with certain benefits, but also come with caveats that potential buyers need to be aware of. Below is an overview of how preferred stocks work, and how investors can decide if it’s the right fit for their portfolio.

What is preferred stock?

Preferred stock looks much like a bond: It pays a contractual dividend, has a par value (or face value) can be redeemed early (often after five years) and may have a fixed maturity date. Unlike bonds, preferred stocks may be able to skip their dividend payments, depending on the type (cumulative or non-cumulative) and some preferreds may not even have a maturity date, being perpetual. Sometimes but not often, preferreds are convertible into common stock.

The key terms you need to know about preferreds include:

• Par value: The face value of the preferred stock, and the typical price at which it is redeemed
• Call date: The date at which the preferred stock can be redeemed, usually five years after issue, though preferred stock may continue to trade perpetually
• Dividend: The preferred stock’s payout.
• Cumulative or non-cumulative: Preferreds are allowed to skip their dividend payment, but cumulative preferreds must eventually make up the payment, while non-cumulative preferreds need not.

Preferred stock is issued with a par value, often $25 per share, and dividends are then paid based on a percentage of that par. For example, if a preferred stock is issued with a par value of $25 and an 8 percent annual dividend, this means the dividend payment will be $2 per share.

Sometimes dividends or yields on preferred shares may be offered as floating, and fluctuate according to a benchmark interest rate.

Preferred stocks often have no maturity date, but they can be redeemed or called by their issuer after a certain date. The call date will depend on the issuing company. There is no minimum or maximum call date, but most companies will set the date five years out from the date of issuance.

Preferred stock is often referred to as a hybrid investment, because it offers characteristics of both a stock and a bond. Legally, it’s considered equity in a company, but it makes payouts like a bond, with regular cash distributions and fixed payment terms.

Preferred stock occupies a middle ground between bonds and common stock. Only after the interest on bonds are paid can holders of a company’s preferred stock be paid. In turn, only after the preferred stock dividend is paid can the company pay dividends on its common stock.

It’s a similar situation in bankruptcy. Preferred stock ranks higher than common stock in the hierarchy of bankruptcy but lower than bonds. Once rents, administrative costs and the first tiers of debt are paid off, then the holders of preferred stock are paid, and only then are holders of common stock entitled to anything. In other words, this kind of stock is “preferred” over the common stock holder.

How does preferred stock work?

Preferred stock vs. bonds

Preferred stocks are like bonds, and both make consistent payments. Also like bonds, preferred stocks can pay a fixed dividend, but may also pay a floating rate that depends on some benchmark interest rate. Unlike debt, payments on preferred stock are not tax-deductible.

Like bonds, preferred stock is offered for sale with a set “face value,” often referred to as par value. This value is how much the issuer will pay back to the owner of the security when it is called or at maturity.

Unlike bonds, preferred stock may not have a maturity date, and can be issued in perpetuity. Preferred stocks issued in perpetuity can pay dividends as long as the company is in business, but the terms of redemption will be outlined in the prospectus. Like bonds, preferred stock may have a call date allowing the issuing company to redeem the stock at some future date, even before its maturity.

A company might choose to call back preferred stock if interest rates fall below the yield of the stock, allowing them to reissue stock at lower yields. If they do so, investors will lose both the income stream and the preferred stock.

One of the biggest differences between bonds and preferred stock, though, is that dividend payments on preferred stock can be deferred. A company must pay the interest on its bonds when it is due or they can be declared in default. In contrast, a company has the ability to defer paying its preferred stock, and may not ever have to repay it, depending on whether the preferred stock is cumulative or non-cumulative (more below).

Dividends – cumulative vs. non-cumulative

Another key aspect of preferred stocks is whether they must pay their dividend at all, and that depends on how the preferred stock was structured:

• A cumulative preferred stock is a type of preferred stock that requires the company to make up for any missed dividend payments, which accrue to preferred stockholders.
• A non-cumulative preferred stock is a type of preferred stock that does not require the company to make up any missed dividend payments.

So non-cumulative dividends can be missed without penalty, whereas cumulative dividends can be missed, but must be paid out later. However, the company cannot pay a dividend to holders of common stock until it has made holders of its preferred stock whole.

When considering purchasing preferred stock, it’s important to take into account whether or not you’re willing to potentially miss out on any unpaid dividends.

Non-cumulative preferreds are typical for bank stocks, whereas REITs typically issue cumulative preferreds.

Preferred stock vs. common stock

Preferred stock is similar to common stock mostly in name only. For legal purposes it’s considered equity, like common stock, rather than debt, though it functions much like debt. Like the payments on common stock, the company is not able to deduct payments to its preferred stock from its taxable income.

Similarly, holders of preferred stock may be able to take advantage of lower tax rates on qualified dividends, which may enjoy a 0, 15 or 20 percent rate, though not all preferreds are able to.

The upside potential of preferred stock is capped, whereas common stock has unlimited upside potential. The price of preferred stock generally changes slowly and is tied to interest rates, while common stock can fluctuate with market conditions, the success of the issuing company and investor sentiment. Preferred stock may also have lower downside.

Preferred stock also usually differs from common stock in its voting rights. Owners of common stock usually have voting rights in the company, but owners of preferred stock rarely do. It will depend on how it is issued, and investors need to take notice before purchasing the stock, if that’s important to them.

Preferred stock may also be called in a way common stock is not. Your preferred stock may be called in at “par,” regardless of what you paid for it.

Other things to consider

Convertible preferred stock

Sometimes a company may issue what is called a convertible preferred stock. This type of stock allows the shareholder to convert preferred stock to common stock at a preset ratio and by some predetermined date.

For example, let’s say Goldman Sachs issues convertible preferred stock at $1,000 with a conversion ratio (the pre-set number of common shares the issuer decides the investor receives at the time of conversion) of 10 and a fixed dividend of 5 percent. The conversion price per common share is thus $100, as the investor will receive 10 shares at $100 each. The decision about whether to convert will depend on where the common stock is trading at the time of conversion.

Conversions are most worthwhile when the underlying asset increases in value, so that an investor can convert preferred stock to common stock and realize the appreciation. However, the price of the convertible preferred will rise to capture the price rise of the common stock.

Given the dividend on the common stock and factors such as further appreciation potential, it may or may not make sense for the investor to convert the preferred to common stock.

It’s important to remember that price increases can be temporary, and if your overall goal is income (or you lean more towards income vs. capital gains) keeping a preferred stock position might be more in line with your overall goals despite a spike in the price of the common stock.

Who is preferred stock best for?

As with all investments, the answer depends on your risk tolerance and investment goals. Preferred stock works well for those who want higher yields than bonds and the potential for more dividends compared to common shares.

In short, preferred stock is riskier than bonds, but safer than common stock.

Preferred stock is also good for investors who don’t want the volatility associated with common stock but still want a decent return. The upside of a preferred stock is usually capped, meaning that this kind of stock has less fluctuation in price than common stock.

Should the preferred stock be purchased at a considerable discount to par value, there is more appreciation potential, but investors have to do the research to find these opportunities.

Examples of preferred stock

Banks are one of the largest issuers of preferred stock, and notable companies with preferred stock include:

• Allstate Insurance
• Goldman Sachs
• AT&T
• Bank of America
• Wells Fargo
• Citigroup
• J.P. Morgan Chase

Several other insurance companies, utility companies and even real estate investment trusts (REITs) such as Public Storage, Annaly Capital and Vornado Realty also offer preferred shares

Financial companies are usually the most likely to offer preferred stock. Preferred securities count towards capital requirements that banks are required to maintain for regulatory purposes, and as such, banks like to issue preferred shares as a way to maintain and raise required capital without giving up voting rights or diluting their common stock.

Bottom line

Preferred stock can have its place in a well-diversified portfolio, but investors should be aware of its downsides. This asset class is sensitive to interest rate fluctuations and offers limited upside potential but offers above-average payouts as a notable positive.