Preferred Stocks: A Deeper Dive (Comparison to Common Stocks & Bonds)
Generally sold with institutional investors in mind, preferred stocks are a form of fixed-income security. Like bonds, preferred shares usually pay dividends, but unlike common stock, they don't usually have voting rights. Additionally, if the company's common stock doubles in value, the preferred stock isn't likely to do the same.
Preferred stocks are often perpetual. Bonds have a defined term from the start, but preferred stocks typically do not. Unless the company calls, or repurchases, the preferred shares, they can remain outstanding indefinitely.
Preferred stock prices are less volatile than common stock prices, which means shares are less prone to losing value, but they’re also less prone to gaining value. In general, preferred stocks are best for investors who prioritize income through dividend yields which are often much higher than dividends on common stock and are fixed at a certain rate. Common stock dividends can change or even get cut entirely.
Both preferred and common stock have a right to a company's profit, but they're prioritized differently. With preferred shares, investors receive a set dividend amount at regular intervals. As long as the company is in good financial standing, they can expect that payout. If, for some reason, a company can't pay its dividend in a period, it will have to make it up to preferred shareholders before it can pay dividends to common stock shareholders. If a company has a $3 dividend but has to skip a payment, the next period, they will owe preferred shareholders $6.
Unlike bonds, preferred stocks are readily tradable on major stock exchanges. Typically, preferred stock ticker symbols are the same as the company's common stock but with an additional letter to designate the series of preferred stock.
Their benefits include:
- Higher dividends.
- Offers the right to be paid before common shareholders if the company ever goes bankrupt.
- Can be converted to common shares.
A preferred stock can fall into some or all of the following categories:
- Convertible. A preferred that is convertible can be converted into common stock at a set price after a set date, usually at the shareholder's option. As that date approaches, the preferred will trade more and more like the common. Convertibles selling at a discount can sometimes offer great opportunities to invest in a company, allowing an investor to receive an income stream while waiting for the common stock to rise before choosing to convert.
- Callable. A callable preferred stock can be called at a fixed price, after a certain period where the company can choose to redeem the shares and pay investors par value. Most preferred stocks are callable, but they tend to get called when interest rates are falling, making other sources of financing more attractive to the company.
- Cumulative. Most preferred stock are cumulative, meaning that if the company ever misses a dividend payment, it will accrue and be owed to stockholders later. Before a common stock dividend can be paid, all payments to preferred stockholders must be up to date. Preferred stock that aren't cumulative usually have a higher yield to compensate for the added risk.
Before purchasing preferred stocks, you can review the credit rating from Moody’s or S&P for each particular offering and take the rating into consideration along with other features, such as yields, callability or convertibility.
The better the credit rating, the more likely the company will be able to continue paying its promised dividends on its preferred stock.
If you’re interested in building a portfolio of preferred shares but don't want to purchase them individually, you can buy an exchange-traded fund (ETF) or mutual fund that focuses on preferred stock.
Exchange-traded funds are a bit of a cross between stocks and mutual funds. A stock is tied to a single company, but an ETF is a fund that has invested in a range of stocks and/or bonds and other assets. Whereas mutual funds often have minimum initial investment amounts that can be as high as several thousand dollars, you can buy as little as a single share of an ETF, which might cost only a few dollars.
An important consideration when investing in stocks is whether you believe in the company’s long-term growth potential and whether the stock complements the other investments you own.
NOTE: Not all public companies issue preferred shares, while all provide common stock.