Preferred stocks explained: what they are and why you should care

Preferred stock vs. common stock: Explained

Preferred and common stocks both represent ownership in a company, but they come with different rights and benefits. Understanding these differences can help you choose the right investment for your portfolio.

Dividend payments

Preferred stocks typically offer fixed dividends, which are paid out before any dividends are issued to common stockholders. This feature makes them similar to bonds, providing a steady income stream. On the other hand, common stocks offer dividends that can fluctuate based on the company's earnings, making them less predictable but potentially more lucrative during prosperous times.

Voting rights

Preferred stockholders generally do not have voting rights, meaning they are less involved in the company's decision-making process. Common stockholders usually have voting rights, giving them a say in corporate governance, such as electing the board of directors.

Claim on assets

In the event of liquidation, preferred stockholders have a higher claim on the company's assets than common stockholders (but a lower claim than bondholders). This priority makes preferred stocks somewhat safer than common stocks, offering a better chance of recouping some of their investment if the company faces financial difficulties.

Price stability

Preferred stocks are generally less volatile than common stocks because their value is more closely tied to interest rates and dividend payments. Common stocks are more susceptible to market fluctuations, reflecting the overall performance of the company and investor sentiment.

Convertibility

Some preferred stocks come with a conversion feature, allowing holders to convert their shares into a predetermined number of common shares. This option provides potential upside if the company's common stock performs well, giving preferred shareholders a chance to benefit from equity growth while still enjoying the stability of fixed dividends.

Callability

Many preferred stocks are callable, meaning the issuing company can repurchase them at a set price after a certain date. This feature is less common with common stocks. While callable preferred stocks offer attractive yields, the callability feature introduces the risk that the shares could be redeemed earlier than expected, potentially limiting future gains.

Types of preferred stocks

There are various types of preferred stocks, each offering different features and benefits that can cater to different investment strategies and risk preferences:

1. Cumulative preferred stock

This type of preferred stock includes a crucial benefit—if a company suspends its dividend payments, the dividends accumulate and must be paid out to cumulative preferred shareholders before any dividends can be distributed to common shareholders.

This feature provides an extra layer of security for income-focused investors, ensuring that missed dividends are eventually paid.

2. Non-cumulative preferred stock

Unlike cumulative preferred stock, non-cumulative preferred stock does not accumulate unpaid dividends. If the company decides not to pay dividends in any given period, those dividends are lost forever for the investor.

This type of stock is riskier but can offer higher potential rewards if the issuing company is financially stable and consistently pays dividends.

3. Participating preferred stock

Participating preferred shareholders have the right to receive additional dividends beyond the fixed rate if the company meets certain financial goals, such as achieving a specified level of profits.

Additionally, in the event of liquidation, participating preferred shareholders may receive the original investment back along with a portion of the remaining proceeds after all debts and other obligations have been settled.

4. Convertible preferred stock

This type of preferred stock offers the option to convert the shares into a predetermined number of common shares. The conversion feature allows investors to benefit from the potential upside of the company's common stock while still enjoying the fixed-income benefits of preferred shares.

It's particularly appealing in scenarios where the company's common stock is expected to appreciate significantly.

5. Perpetual preferred stock

Perpetual preferred stocks do not have a maturity date, meaning they can potentially pay dividends indefinitely, as long as the issuing company remains in operation and decides to continue the dividend payments.

This type of stock can be attractive to investors looking for a long-term income stream without the concern of maturity.

6. Callable preferred stock

Also known as redeemable preferred stock, this type can be called (redeemed) by the issuing company after a certain date at a predetermined price. Companies might opt to call their preferred shares if interest rates drop, allowing them to issue new shares at a lower dividend rate.

For investors, callable preferred stock offers higher initial yields to compensate for the call risk, but there's a chance the stock could be redeemed before expected, limiting potential gains.

7. Adjustable-rate preferred stock (ARPS)

ARPS has dividend rates that periodically adjust based on a predetermined benchmark, such as the US Treasury bill rate or the LIBOR. This type of preferred stock can offer some protection against interest rate fluctuations, making it appealing during periods of rising interest rates.

8. Trust preferred stock

Issued by financial institutions, trust preferred stocks combine features of both debt and equity. They are technically a form of debt but are treated as equity on the issuer's balance sheet. These stocks typically offer high dividends, but they also carry the risks associated with both bonds and preferred equity. 

What are the downsides of buying preferred stocks?

Preferred stocks come with certain benefits, but they also have disadvantages.

Here are five considerations you should take before investing in them:

Limited capital appreciation

Unlike common stocks, preferred stocks generally offer limited potential for price appreciation. They are designed primarily for income generation through dividends rather than for growth. This means that while you might enjoy steady dividend payments, you won't typically see the value of your investment increase as significantly as it might with common stocks.

Interest rate sensitivity

Preferred stocks are more sensitive to interest rate changes than common stocks. When interest rates rise, the value of preferred stocks tends to decrease because their fixed dividend payments become less attractive compared to new issues with higher yields. This can lead to price volatility that some investors might find concerning, particularly in a rising rate environment.

Dividend payment risks

While preferred stocks generally offer fixed dividends, these payments are not guaranteed. Companies can suspend dividend payments on preferred shares, especially non-cumulative ones, during financial difficulties. This makes them less reliable than bonds, where interest payments are a legal obligation.

Call risk

Many preferred stocks are callable, meaning the issuing company can repurchase them at a predetermined price after a certain date. If interest rates decline, companies may choose to call their higher-yielding preferred stocks and reissue them at a lower rate, leaving investors with cash that they must reinvest at lower prevailing yields.

Inflation risk

Preferred stocks pay fixed dividends, which can lose purchasing power over time due to inflation. In an inflationary environment, the real value of the dividends received diminishes, making these investments less attractive compared to other assets that might offer inflation protection, such as common stocks or inflation-indexed bonds.

How to buy preferred stocks

To buy preferred stocks, investors will need to open an account with a bank or broker that deals in them. They can then purchase preferred stocks the same way they purchase common stocks.

Conclusion: Balancing the benefits of preferred stocks

Preferred stocks can potentially be a solid addition to your portfolio if you're looking for a steady income with less risk than common stocks. They blend stability and income potential, and that appeals to those who value reliability over rapid growth.

However, it’s important to weigh the trade-offs. While they may offer predictable dividends, preferred stocks may not provide the same long-term appreciation as other investments, and they can be affected by changes in interest rates. Before deciding if preferred stocks are right for you, think about your financial goals and how comfortable you are with their unique risks.