A preferred stock is a hybrid instrument that combines characteristics of both common stocks and bonds. Preferred stock is less risky than regular stock but riskier than bonds.
Investors wishing to purchase stock in a firm may have two options: preferred stock (also known as preferred shares or preferreds) or common stock.
What is a preferred stock?
Preferred stock is a share of a corporation that is similar to a normal (or common) stock, except preferred equities provide additional shareholder protections. When it comes to dividend payments, for example, preferred investors have precedence over regular stockholders.
Preferred stockholders are also ranked higher in the company’s capital structure (which implies they will be paid out before common shareholders in the event of an asset liquidation). As a result, preferred stocks are less risky than regular stocks but more hazardous than bonds.
How do preferred stocks work?
While preferred stock and ordinary stock share a name, they are not the same when it comes to risks and benefits.
Preferred stocks, in many respects, perform more like bonds, which are fixed-income investments.
Preferred stocks often payout set dividends on a consistent basis.
Preferred stocks, like other fixed-income instruments that have an inverse connection with interest rates, may react to changes in interest rates.
Preferred stocks, like bonds, have a “par value” at which they may be redeemed, which is normally $25 per share. Both may be repurchased, or “called,” by the issuer after a certain amount of time, usually five years.
What you should know about preferred stock
Preferred stocks offer specific advantages that bonds do not enjoy. Preferreds are unique in the world of fixed-income instruments because of these characteristics. They also make preferred stock more flexible for the corporation than bonds, therefore preferred stock often pays a greater dividend to investors.
- Preferred stock” is often perpetual. Bonds have a fixed period from the outset, while preferred stock does not. The preferred shares may stay outstanding forever until the firm calls — that is, repurchases — them.
- Preferred dividends may be delayed (and in certain cases missed completely) without consequence. This feature is specific to preferred shares and will be used if a company is unable to make a dividend payment. Cumulative preferred stocks may postpone but not cancel the dividend; the corporation must pay the dividend at a later date. Noncumulative preferred equities are exempt from paying dividends if they are not cumulative. This, however, will make it harder for the corporation to obtain capital in the future.
- Convertible preferred stock is available. Some preferred stocks may allow holders to convert or swap their preferred shares for a set number of shares of common stock at a set price.
Bonds vs. preferred stock vs. ordinary stock
Preferred stocks may be an appealing option for people looking for consistent income with a bigger payout than ordinary stock dividends or bonds. However, they forego the unconstrained upward potential of ordinary stocks as well as the security of bonds.
A firm often offers preferred stock for many of the same reasons as it issues bonds, and investors like preferred stock for similar reasons. Preferred stock and bonds are easy alternatives for a corporation to obtain funds without issuing more expensive ordinary stock. Preferred stock is popular among investors because it often offers a greater dividend than the company’s bonds.
So, if preferred stocks provide a greater dividend yield, why wouldn’t investors choose them over bonds? In a nutshell, preferred stock is riskier than bonds. In order of risk, we describe the distinctions in each asset type below.
Bonds: Bonds are often the safest option for an investor to invest in a publicly listed corporation. Bond interest must be paid before dividends on preferred or ordinary stock, according to the law. If the firm went bankrupt, bondholders would be paid first if any money was leftover. Investors are ready to accept a lesser interest payment in exchange for this security, implying that bonds are a low-risk, low-reward investment.
Preferred stock: Preferred stock is the next in line. Shareholders are ready to take a back seat behind bonds but ahead of ordinary stock in return for a larger payment. (The term “preferred stock” derives from their favored position above ordinary shares.) Preferred holders may get their dividends after bondholders have received theirs. As previously stated, a company’s dividend distributions might occasionally be skipped, adding risk. As a result, preferred stocks provide a higher payment in exchange for a higher level of risk, but their potential return is typically limited to the dividend distribution.
Common stock: Common shareholders come in last, receiving payment only if the corporation is paying a dividend and everyone in front of them has gotten their entire payout. In the case of a company’s bankruptcy, these investors get whatever remains after bondholders and preferred stockholders have been paid whole. However, unlike bonds and preferreds, there is no upside limit on a common stockholder’s gains if the firm succeeds. The sky is indeed the limit.
|Bonds||Preferred stock||Common stock|
|Ownership stake in company||Debt holder||Equity owner||Equity owner|
|Upside / growth potential||Limited||Limited, unless convertible||Unlimited|
|Risk||Least risk and price volatility||Medium risk and price volatility||Most risk and price volatility|
|Voting rights||None||Typically none||Proportional to ownership level|
|Distribution of assets (in bankruptcy)||Interest must be paid before dividends||Paid after bondholders but before common shareholders||Last if funds remain after paying bondholders and preferred holders|
|Payout||Guaranteed interest at lower yield than preferreds||Fixed dividends with higher yield than bonds or common stock dividends||Dividends are not guaranteed|
How to buy Preferred Stock
Preferred stocks are traded on exchanges that are comparable to ordinary stock markets, allowing for price transparency. However, since most businesses do not issue preferred shares, the entire market for them is tiny, and liquidity might be constrained. Banks, insurance firms, utilities, and real estate investment trusts, or REITs, are the most popular issuers of preferred stock.
Companies issuing preferreds may have many offerings for you to evaluate. It is not uncommon to see multiple distinct offers of preferreds from the same issuer, each with a different yield. An investor may study the credit rating from Moody’s or S&P for each specific offering before acquiring preferreds, and take the rating into account along with other aspects such as yields, callability, or convertibility.
Preferreds may be purchased in any brokerage account, although their ticker symbols will vary from those of ordinary stock. Make careful to double-check all of the specifics to guarantee you’re getting exactly what you’re looking for.
An investor may decrease investment risk by applying diversification to their preferred stock portfolio, just as they do with other stock and bond investments. One method is to invest in preferreds via an ETF or mutual fund, which enables you to acquire a portfolio of preferred equities while minimizing the risk associated with a single offering.