Preferred Stock

Quick Definition

Preferred stock is a class of corporate equity that receives priority over common stock in dividend payments and asset claims during bankruptcy or liquidation, but typically carries no voting rights. It pays a fixed or adjustable dividend — similar to a bond's coupon — and trades on stock exchanges like common stock. Preferred stock sits between bonds (most senior) and common stock (least senior) in a company's capital structure.

What It Means

The word "preferred" reflects the priority treatment these shareholders receive. When a company distributes dividends, preferred stockholders are paid first. If the company is liquidated, preferred shareholders stand in line ahead of common stockholders to reclaim assets (though behind bondholders and other creditors).

In exchange for this priority, preferred shareholders typically sacrifice the voting rights that common stockholders have. They also give up unlimited upside — while common stock can theoretically increase without bound, preferred stock's price is largely anchored to its dividend yield, much like a bond's price moves with interest rates.

Preferred stock is most commonly issued by:

• Banks and financial institutions
• Utilities
• Real estate investment trusts (REITs)
• Companies in capital-intensive industries

Types of Preferred Stock

Preferred Stock vs. Common Stock vs. Bonds

This comparison is the foundation for understanding preferred stock:

How Preferred Stock Dividends Work

Calculating Dividend Yield

Most preferred stock is issued with a par value (typically $25) and a stated dividend rate:

Annual Dividend = Par Value × Stated Rate Dividend Yield = Annual Dividend / Current Market Price

Example: A preferred share with $25 par value and 6% stated rate:

• Annual dividend: $25 × 6% = $1.50/year ($0.375/quarter)
• If trading at $25 (par): Yield = $1.50 / $25 = 6.0%
• If trading at $22 (discount): Yield = $1.50 / $22 = 6.82%
• If trading at $27 (premium): Yield = $1.50 / $27 = 5.56%

Cumulative Dividends: The Protection Feature

Scenario: A company with cumulative preferred stock skips dividend payments for two years during financial difficulty.

Non-cumulative preferred holders would receive nothing for years 1 and 2 and have no claim to make it up.

How Preferred Stock Price Behaves

Because preferred stock pays a fixed dividend, its price moves inversely with interest rates — just like bonds:

Example: You buy preferred stock at $25 par paying 6% ($1.50/year). Then market rates rise to 8%. New preferred shares are now issued at 8%. Your 6% shares must fall in price so their effective yield matches 8%:

• New price = $1.50 / 0.08 = $18.75
• You have lost $6.25 per share (25%) in price

This interest rate risk is the primary risk of holding preferred stock long-term.

Call Risk: The Hidden Danger

Most preferred stock is callable — the issuing company can redeem shares at par ($25) after a specified date (usually 5 years from issue). This creates a problem called "call risk":

Scenario: You buy preferred stock at $27 (premium), paying 7% yield. Rates fall to 4%. The company calls the shares at $25.

• You paid: $27
• You receive: $25
• Capital loss: $2 per share (7.4%)
• Meanwhile, reinvesting at current 4% rates means your income falls

Callable preferred stock is generally not advantageous to hold at a significant premium to par for this reason.

Who Buys Preferred Stock

Preferred stock is primarily purchased by:

1. Income investors: Seeking higher, more reliable yield than common stock dividends
2. Institutional investors: Insurance companies, banks, and mutual funds
3. Corporate investors: Other corporations (who receive a 50-70% dividend received deduction on preferred dividends — reducing their effective tax rate on this income)
4. Retirees: Seeking fixed income with equity-like features

Preferred Stock in Practice: Real Examples

Major US companies with notable preferred stock programs:

Risks of Preferred Stock

Preferred Stock ETFs (The Easy Way to Invest)

Most retail investors access preferred stock through ETFs:

These ETFs provide diversification across dozens or hundreds of preferred issues, eliminating the idiosyncratic risk of holding individual preferreds.

Key Points to Remember

• Preferred stock is a hybrid — equity by classification but bond-like in behavior (fixed dividend, interest rate sensitive)
• Preferred shareholders receive dividend priority over common stockholders but are behind all debt holders in bankruptcy
• Most preferred is non-voting — you have an economic claim but no voice in company governance
• Cumulative preferred protects your dividend rights even if payments are skipped; non-cumulative does not
• Preferred prices fall when interest rates rise — the primary ongoing risk
• Call risk means the issuer can buy back shares at par when rates fall, limiting upside and reinvestment options

Frequently Asked Questions

Q: Are preferred stock dividends qualified for the lower dividend tax rate? A: Some are, some are not. Qualified preferred dividends are taxed at the lower long-term capital gains rate (0%, 15%, or 20% depending on income). Non-qualified preferred dividends are taxed as ordinary income. The tax treatment depends on the structure of the preferred and how long you have held it. Check the issuer's documentation or your 1099-DIV — qualified dividends are reported separately.

Q: Should I prefer preferred stock over bonds for income? A: Preferred stock typically offers higher yields than investment-grade corporate bonds to compensate for being junior in the capital structure and carrying more uncertainty. However, preferred dividends are not contractually required the way bond interest is — a company in distress will skip preferred dividends before defaulting on bonds. For safety, bonds rank higher. For yield, preferreds often win. For most income investors, a mix of both makes sense.

Q: What happens to preferred stock if a company goes bankrupt? A: Preferred stockholders have a claim on the company's assets ahead of common stockholders, but behind all creditors (bondholders, trade creditors, secured lenders). In most corporate bankruptcies, common and preferred stockholders receive little to nothing because creditors' claims consume the available assets. Preferred status matters mainly in partial recoveries or restructuring scenarios.

Q: Is convertible preferred stock better than regular preferred? A: It depends on your goals. Convertible preferred gives you the option to exchange your preferred shares for common stock at a predetermined price. This captures upside if the common stock rises significantly, while still protecting you with the preferred dividend and priority if things go poorly. The tradeoff is that convertible preferred typically offers a lower dividend yield than comparable non-convertible preferred.