While bonds are higher in priority of payout than preferred stocks, preferred shares have priority over common stock dividends. Most companies do not offer preferred stock, but many of those that do are banks and insurance companies, for example.
How Does Preferred Stock Work?
If a company needs to liquidate assets in a bankruptcy proceeding, preferred stockholders will receive their payments before the common stockholders (but not before the creditors and bondholders—in that order). The trade-off for the often substantially higher dividend yield received by preferred stockholders is the relative inability to actualize capital gains. This means that any capital gains you enjoy will likely come from buying a preferred stock before an interest rate decline. Similarly, an increase in a firm’s creditworthiness could also increase the firm’s preferred stock value.
Types of Preferred Stock
There are generally four categories of preferred stock. Each type is named for the action that the company takes for or against the share. The terms of preferred stocks can vary widely. The same company may issue two preferred stocks, but there can be differences if the shares weren’t issued as part of the same preferred stock “series.” Arguably, the most crucial characteristic of preferred stock is whether or not the dividend is cumulative or non-cumulative.
Callable Preferred Shares
As implied by its name, the issuing company can call the share back (repurchase it) at a predetermined price. Generally, corporations issue callable stocks to avoid paying higher interest rates for extended periods.
Convertible
As its name states, a convertible share is a preferred share you can convert to a common share. If you’re a preferred shareholder, you might have various reasons for doing this. However, the most common reason to exchange shares is if the common stocks are performing better. Your investment is unaffected by the price of common stock until you convert your shares. Under the right conditions, you can make a lot of money while enjoying higher income and lower risk by investing in convertible preferred stock. When converting a preferred share to a common one, the risk you take is that you cannot convert them back to a preferred share.
Cumulative
Company financial performance can be fickle. Sometimes they have enough revenues to pay their shareholders, and sometimes not. If the issuers of the cumulative stock guaranteed dividends and miss a payout period, they are required to pay the cumulative amount they owe before giving common stock dividends. For example, if the company missed two periods, they must pay you the dividends from both periods before paying common stock dividends. Non-cumulative stocks do not create dividends in arrears if the company cannot pay dividends. If the company that issued your non-cumulative preferred stock generates a loss for the year, you might not see anything from them until they are profitable again.
Participatory
Participatory shares are stocks that receive fixed dividends. The difference is that participatory shareholders may get more than the fixed dividends if the company has higher revenues than anticipated. Companies can use fixed amounts or percentages for calculating the additional earnings. For example, the additional earnings could be calculated as a percentage of either the net income or the dividend paid to the common stockholders.
What It Means for Individual Investors
Several additional provisions can affect the value of a preferred stock. These considerations include shareholder voting rights, the rate of interest, and whether or not the shares can be converted to common shares.
Voting vs. Non-Voting
Owners of preferred stock usually do not have voting rights. There have been cases throughout history in which preferred shares only received voting rights if dividends had not been paid for a specific length of time. In such cases, significant—if not controlling—voting power can be effectively transferred to the preferred shareholders.
Adjustable-Rate Dividends
Holders of preferred stock receive a dividend that differs based on any number of factors stipulated by the company at the issuer’s initial public offering. Preferred stock issues may also establish adjustable-rate dividends (also known as floating-rate dividends) to reduce the interest rate sensitivity and make them more competitive.
Price Stability
If a large drug company discovered a cure for the common cold, one could reasonably expect the company’s common stock to skyrocket. The growth in market value is in anticipation of earnings growth from sales of the new drug. At the same time, the company’s preferred shares likely wouldn’t budge much in price, except to the extent that the preferred dividend is now safer due to the higher earnings. This additional safety can lead to the market value of the preferred shares rising (which causes the yield to fall), but the movement is unlikely to match that of the common stock. If that same drug company later announced that they no longer believe the cure is effective, the common stock price would likely plummet. The preferred stock price would likely remain relatively stable.
The Bottom Line
Preferred stock performs differently from common stock, and investors should be aware of those differences before investing. The strategies that work best with common stock may not work with preferred stock, and vice versa. If you prefer to buy-and-hold investments and emphasize dividend earnings, a preferred stock might have a place in your portfolio.
