What is Preferred Stock?
Preferred stock is a class of shares, which represent partial ownership in a corporation. However, it does not typically convey voting rights to the holder. Preferred stock combines the features of common stock and bonds. Like a bond, it pays fixed dividends. It also has the potential to increase in value like common stock and gain equity.
Preferred stocks can have perpetual or long-term maturity. Perpetual preferred stock does not have a maturity date. Long-term maturity periods range from 30 – 50 years. Because of callable provisions, most preferred stocks do not reach their full maturity.
Understanding the investment spectrum
Corporate investments may be grouped into three categories: bonds, preferred stocks, and common stock. There are other types of investments, but to explain preferred stock, we will narrow it to these three.
Bonds are the most stable investment since they pay regular dividends over a specified period. Bond owners typically have voting rights. When a company pays dividends or discharges its debt, bonds are paid first.
At the other end of the spectrum is common stock. It is the least stable investment, which means it may earn substantially more or experience a significant price drop. When the corporation pays dividends or enters bankruptcy proceedings, common stockholders are the last to be paid.
Preferred stock falls squarely between the other two categories. It pays dividends over time, so it provides a steady income. In day-to-day operations, preferred stockholders have no voting rights. However, if the company files bankruptcy or liquidates, they may have a say in what happens. When the company discharges a debt or pays dividends, preferred stock owners are paid after bondholders, but before common stockholders.
Receiving dividends on preferred stock
Your preferred stock investment may pay dividends monthly or quarterly. Dividends are calculated based on the par value of the stock. Par value sets the stock’s maturity value and face value.
For example, $25 is a common value for preferred stock shares. If the stock offers a 10% dividend rate, the shareholder will receive $2.50 each time it pays dividends. Here is where frequency matters. If the same stock pays monthly dividends, the shareholder will make $30 in a year. If dividends are paid quarterly, the shareholder will only receive $10.
Ideally, the preferred stock issuer pays dividends on a regular schedule. However, if the company is experiencing financial difficulty, they may exercise their option not to pay dividends. Depending on the type of preferred stock, the investor may miss the payment, or it may be paid later.
Exploring types of preferred stock
Preferred stock may have several different provisions. Here are some of the most common ones.
Callable preferred stock
Most preferred stock is callable, which can significantly affect the investment. Market demands can cause fluctuation in stock price. For instance, if preferred stock shares offer 9 percent interest and the market demands 9 percent, they will trade at, or close to, par value. However, if market demand drops to 8.5 percent interest and the stock offer is at 9 percent, the preferred stock price will go up.
If the shares are callable, the company can simply pay preferred stockholders the par value of the shares when the price goes up. In other words, about the time the stock gains significant value, the issuer can pay a much lower price to call the stock. They can then re-issue it at a lower percentage rate.
Cumulative preferred stock
This type of preferred stock offers investors some protection if the company cannot pay dividends for a particular period. Even though dividends are not paid when they are due, they are still credited to the shares. When the issuer’s financial position gains stability, they make current and missed dividend payments to the shareholder.
Convertible preferred stock
Convertible preferred stock offers versatility since it can be converted to common stock shares. The conversion may be based on a specific stock price or have a mandatory conversion date. This can benefit investors because it allows them to take advantage of rising stock prices and bypass a call on preferred stock.
Participating preferred stock
On occasion, a corporation will issue participating shares. This type of preferred stock pays extra dividends. For example, the company may issue a special year-end dividend as a “thank you” to shareholders. If the preferred stock has a participating feature, its shareholder will receive part of this payment.
Taking advantage of preferred stock benefits
Most preferred stock buyers tend to be business institutions. This is because corporate structures can use them as a tax write-off. Individuals do not receive the same benefit. The write-off works because preferred stocks fall between bonds and common stocks. On tax returns, they function as debt; on company books, they count as investment stock assets.
Companies issue preferred stock because corporate investors buy them in bulk. This makes it an easy way to raise large amounts of capital. Because the stock pays dividends, the company repays small amounts over time rather than having the entire debt come due at once.
If the preferred stock is callable, it becomes an even more attractive way to raise capital. Call provisions ensure that if market rates drop substantially, the company can minimize its losses, then re-issue new stock at a lower rate.
Avoiding issues with preferred stock
The same call feature that is a boon to companies raising capital, can be a pitfall for investors. If a company calls preferred stock, the investor may lose money. Furthermore, these shares tend to trade close to their par value. Receiving a dollar more than par value in a sale represents a significant gain.
Preferred stocks are given a credit rating. Only a handful attain the highest AAA or AA ratings, and only a little over 10 percent are rated A or higher. Investment advisors frequently refer to low-rated investments as junk bonds.
Still, the tax benefits and versatility of preferred stock appeal to many corporate investors. When chosen wisely, these stocks can provide companies with a steady stream of income. If you need help attracting investors or deciding which provisions would benefit your business portfolio, ask an Expert. They can help you understand the pros and cons of issuing or investing in preferred stock.