Why companies issue preferred stock is different than the reason they go public and offer common stock. Preferred stock is a form of equity, or a stake in the company's ownership. Instead of being a form of debt equity, preferred stock works more like a bond than it does like a share in a company. Companies issue preferred stock as a way to obtain equity financing without sacrificing voting rights. This can also be a way to avoid a hostile takeover. A preference share is a crossover between bonds and common shares.

Preferred Shareholders Are Higher in the Payout Order

While basically a form of stock investment, preferred stockholders are in the payout lineup right behind the debt holders in a company's credit holder lineup. Common stockholders fall in line to receive payment after preferred shareholders, but if the company folds, all debt holders get paid before any stockholders, preferred or common. Demand is the driving force behind the issuance of preferred shares. These shares are wanted by investors. Preference shares are valued by investors as a way to reduce risk while ensuring preferred status for payment if the company files bankruptcy.

Perpetual, Long-Term Investments

Think of preferred stock as a long-term investment. These shares have terms from 30 to 50 years in length, or are perpetual with no maturity date no matter how long they are held. Plus, some of the 30-year stocks can be extended for an extra 19 years if desired. Preferred shareholders receive a return that's based on dividend yield, and this can be a floating or a fixed rate. This differs from how common stock shareholders, who benefit whenever a company grows, are paid.

Call Provisions and Risk

One potential drawback preferred shareholders face is that a call provision is usually part of the equation. Call provisions, along with preferred stock's long time to maturity, are considered undesirable by some investors. Fixed income investing in stock with long-term maturities have proven to offer the weakest risk/reward benefits, meaning investors see the lowest return for the amount of risk they incur.

Long-Term Debt Instruments With No Callback Provisions

The United States government issues long-term debt instruments that don't have a callback provision.

  • This means the issuer has the right to prepay the debt but isn't forced to do that.
  • With government debt and other non-callable forms of debt, there is a symmetrically-balanced price risk.
  • That means when interest rates go up or down, the price of the non-callable bond goes up or down the exact same amount, but in the opposite way.
  • This differs from preferred stock that's callable.
  • When preferred stock drops as interest rates rise, the issuer can call it and replace it with lower rated preferred stock or even common stock if they choose.
  • So, preferred stock has an asymmetric risk because they carry long-term risk but the call feature limits the number of rewards for your long-term investment.

Par Value of Preferred Stocks

Preferred stocks usually trade right around par value, and almost all preferred stock issued is callable at par value. The benefits of preferred stock are very limited, and when the call date is near, there's almost no upside. Preferred stocks are rarely ever rated highly and are sometimes called junk bonds, though not all qualify as junk bonds. Long-term investors who are focused on earning dividends at a fixed rate of return choose preferred stocks. This is a way to earn a fixed rate of return and avoid the rising and falling values of common shares in the stock market.

Low Debt-to-Equity Ratios

Issuing preferred shares can help a company achieve a lower debt-to-equity ratio compared to issuing debt bonds. Companies use this technique to manage balance sheets. This makes the stock look more appealing to potential investors who usually opt to invest in companies with lower debt-to-equity ratios.

Companies that need more financing might also be forced to issue preferred shares rather than trigger a callback on bonds that were issued previously via a technical default. A technical default is triggered when a company's debt-to-equity ratio goes over a preset limit noted in the currently issued bond covenant. It can also help companies avoid the need to increase interest rates on previously issued bonds.

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