1. What Is a Preferred Stock?
2. Preferred Shares: Voting Rights, Calling, and Convertibility
3. Typical Buyers of Preferred Stock

Preferred stock ownership occurs when an investor purchases ownership in a public company. Preferred stock carries some of the qualities of both common stock and bonds.

What Is a Preferred Stock?

The price of a share of both preferred and common stock varies with the earnings of the company. Similar to common stock, preferred stock also pays a dividend. Dividends of preferred stock are almost always paid out prior to the payment of dividends to common stock.

Unlike common stock, preferred shareholders do not receive voting rights. Preferred stock is considered to be a hybrid between corporate bonds and common stock; this is because the dividend payment is paid out at a fixed rate. It also provides the added benefit of having the potential to appreciate in price.

Preferred shareholders are typically paid a guaranteed divided. Meaning that they have first priority to any dividends that are issued. In other words, common stock shareholders will not receive a dividend payment before the preferred shareholders have received the total amount due to them.

In a liquidation scenario, preferred stock shareholders will always have priority over common stock shareholders, but they will not have precedence over bondholders, creditors, general creditors, or secured creditors. If dividend payments are ever suspended, preferred shareholders have the right to collect all dividends in arrears before any dividend payment can be restarted for common stockholders. Shares with this feature are referred to as cumulative preferred stock.

Companies with multiple coinciding issues of preferred stock may have to rank them in order to establish a priority. The highest rank is referred to as prior, followed by the first preference, second preference, etc. Preferred stock offers holders with predictable fixed dividend payments that are regularly rated by credit rating agencies. If the company does not pay a dividend to a preferred shareholder, it will not put the company into default. The rating received on preferred shares versus corporate bonds for the same company are usually lower because preferred shareholders are not receiving as good a guarantee.

Preferred Shares: Voting Rights, Calling, and Convertibility

Preferred shareholders typically do not have voting rights. However, certain preferred shares may be issued with a disclosure that gives them the right to vote if they haven't received their dividends. Preferred shares are frequently issued at the price of $25 and are consistently traded within a couple of dollars of the issue price.

The organization's credit-worthiness will determine whether the preferred stock trades at a premium or a discount. Other reasons include:

  • The priority to other issues
  • Whether the shares are cumulative
  • Whether the shares are callable

When shares are callable, the company that issued the stock can purchase the shares from the stockholder at par value. There's usually a future date that determines eligibility. For example, if interest rates decrease, the company may buy back the shares and reissue new shares with a lower interest rate payment. If the business never exercises the call, the shares will continue to be traded on the open market.

Convertible preferred stock allows the shareholder to exchange their preferred shares for common stock. Various reasons for exchanging include:

  • The shareholder has the option to covert
  • The board of directors may have voted to convert
  • The stock may have a set date where it automatically converts

Typical Buyers of Preferred Stock

Most shares of preferred stock have no maturity date or one that's in the very distant future. Certain tax advantages encourage institutions to purchase preferred stock. These same tax benefits are not available to individuals and therefore discourage the purchase. Institutions will usually purchase the stock in bulk and consequently allow the company to raise a large amount of capital in a short amount of time.

Companies that offer preferred stock usually are in the higher and lower limits of the credit-worthiness spectrum. For example, a company may not be able to offer additional bonds because they've been downgraded, but they may still be allowed to issue preferred stock.

Preferred stock is actually equity and is similar to a bond in many ways. For example, trust preferred stock acts as a debt from a tax viewpoint and common stock on the balance sheet. Many companies in the S&P 500 issue preferred stock in order to finance big projects.

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