How Does Preferred Stock Work?

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

Preferred shares are sometimes called hybrid securities. In this article, we take a look at preferred stocks and compare them to some better-known investment vehicles.

Understanding Preferred Shares

A company may choose to issue preferred stock for several reasons:

• Payment flexibility. Preferred dividends can be suspended if the company has cash flow problems.
• Easier to market. Preferred shares are typically purchased and owned by institutional investors, which can make it easier to market them in an initial public offering.

Preferred stocks are attractive because they generally offer higher fixed income payouts than bonds with a lower investment per share. Preferred stockholders also have a priority claim on common stock for payment of dividends and liquidation proceeds. Its price is generally more stable than that of ordinary shares. In addition, it is more liquid than corporate bonds of similar quality.

Preferred shares often have a redeemable feature that allows the issuing company to forcibly cancel outstanding shares for cash. This prevents the investor from participating in any future price appreciation. It also does not specify the maturity date, which creates uncertainty as to the recovery of the principal invested. The upside potential is limited, there are no voting rights and it is interest rate sensitive.

Internal Revenue Service (IRS) rules make it attractive for institutions to invest in preferred stocks. Under what is known as the Dividend Received Deduction, a US corporation receiving dividends from a domestic corporation can deduct up to 50% of income from its taxes if it owns less than 20% of the dividend payer. If the company owns more than 20% of the dividend payer, it can deduct 65%.

However, the fact that individuals are not eligible for such favorable tax treatment should not prevent preferred shares from being considered a viable investment.

Types of Preferred Shares

Although the possibilities are nearly endless, here are the basic types of preferred stock:

• Cumulative. Most preferred stocks are cumulative, which means that if the company withholds some or all of the expected dividends, they are considered late dividends and must be paid before any other dividends. Preferred shares that do not carry the cumulative feature are called straight or non-cumulative preferred.
• callable. Most preferred shares are redeemable, which gives the issuer the right to redeem the shares on a date and at a price specified in the prospectus.
• Convertible. The time of conversion and the conversion price specific to the individual issue will be set forth in the prospectus of the preferred share.
• Participant. These are preferred stocks that have a fixed dividend rate. If the company issues participating preferred shares, those shares have the potential to earn more than their quoted rate. The exact participation formula can be found in the prospectus. Most of the favorites do not participate.
• Adjustable Rate Preferred Shares (ARPS). These preferred shares pay dividends based on several factors stipulated by the company. Dividends for ARPS are indexed to US government issue yields, providing the investor with limited protection against unfavorable interest rate markets.

Bonds and Preferred

Because preferred stocks are often compared to bonds and other debt securities, let’s take a look at their similarities and differences.

Similarities

Preferred shares are issued with a fixed face value and pay dividends based on a percentage of that face value, usually at a fixed rate. Like bonds, which also make fixed payments, the market value of preferred stocks is sensitive to changes in interest rates. If interest rates rise, the value of preferred stock declines. If rates fall, the opposite would be true. However, the relative evolution of preferred yields is generally less spectacular than that of bonds.

Preferred shares technically have an indefinite life because they don’t have a fixed maturity date, but they can be called by the issuer after a certain date. The motivation for redemption is generally the same as for bonds—a company calls securities that pay higher rates than what the market is currently offering. Also, as with bonds, the redemption price may be above par to improve the initial marketability of the preferred stock.

Like bonds, preferred stocks are superior to common stock. However, bonds have more seniority than preferred stocks. Preferred stock seniority applies to both the distribution of company profits (in the form of dividends) and the liquidation of proceeds in the event of bankruptcy. With preferred stock, the investor stands closer to first tier for payout than common stockholders, but not by much.

As with convertible bonds, preferred stock can often be converted into common stock of the issuing company. This feature provides investors with the flexibility to lock in the fixed preferred dividend yield and potentially participate in the capital appreciation of common shares.

Like bonds, preferred stocks are rated by major rating companies, such as Standard & Poor’s and Moody’s. The rating of preferred shares is usually one or two levels lower than that of bonds of the same company, because preferred dividends do not carry the same guarantees as the interest payments of bonds and they are lower than all creditors.

Differences

As observed earlier, preferred stocks are stocks while bonds are debts. Most debt securities, as well as most creditors, have priority any equity.

The privileged pay dividends. These are fixed dividends, normally for the life of the shares, but must be declared by the company’s board of directors. As such, there is not the same range of guarantees as those offered to bondholders. With preferred stock, if a company has a cash flow problem, the board of directors can decide to withhold preferred dividends.

The trust deed prevents companies from taking the same action on their corporate obligations. Another difference is that preferred dividends are paid out of 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 stock.

Calculating current yields on preferred stocks is similar to calculating on bonds where the annual dividend is divided by the price. For example, if a preferred stock pays an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75 ÷ $25 = 0.07, or 7%. However, in the market, preferred stock yields are generally upper than bonds of the same issuer, reflecting the higher risk that preferred shares present to investors.

Although preferred stocks are interest rate sensitive, they are not as sensitive to interest rate fluctuations as bonds. However, their prices reflect general market factors that affect their issuers to a greater extent than bonds from the same issuer.

Information about a company’s preferred stock is easier to obtain than information about the company’s bonds, which makes preferred stock, in a general sense, easier to trade (and perhaps more liquid). The low par values ​​of preferred stocks also make investing easier, as bonds (with par values ​​around $1,000) often have minimum purchase requirements.

Common shares and preferred shares

Similarities

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

Preferred shares have fixed dividends and although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if any, are paid after the company’s obligations to all preferred shareholders have been satisfied.

This is where preferred stocks lose their shine for many investors. If, for example, a research-based pharmaceutical company finds an effective cure for the flu, its common stock will skyrocket, while preferred stock might rise only a few points. The lower volatility of preferred stocks may seem attractive, but it works both ways: preferred stocks are not as sensitive to a company’s losses, but they will not participate in a company’s success to the same degree as ordinary actions.

While common stock is often referred to as voting stock, preferred stock generally does not have voting rights.

The essential

An individual investor looking for preferred shares should carefully consider their pros and cons. There are a number of strong companies in stable industries that issue preferred stocks that pay higher dividends than investment-grade bonds. The starting point for researching a specific preference 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.