Investors looking to buy stock in a company may be able to choose between two main types of stock: preferred stock (aka preferred shares or preferreds) or common stock.
What is a preferred stock?
A preferred stock is a share of a company just like a regular (or common) stock, but preferred stocks include some added protections for shareholders. For example, preferred stockholders get priority over common stockholders when it comes to dividend payments.
Preferred stockholders also rank higher in the company’s capital structure (which means they’ll be paid out before common shareholders during a liquidation of assets). Thus, preferred stocks are generally considered less risky than common stocks, but more risky than bonds.
How preferred stocks work
While preferred stock shares a name with common stock, don’t get them confused: They’re a world apart when it comes to risks and rewards.
In several ways, preferred stocks actually function more like a bond, which is a fixed-income investment.
Preferred stocks typically pay out fixed dividends on a regular schedule.
Similar to other fixed-income securities, which have an inverse relationship with interest rates, preferred stocks may respond to changes in interest rates.
Like bonds, preferred stocks have a “par value” they can be redeemed at, typically $25 per share. And both can be repurchased, or “called,” by the issuer after a certain period, often five years.
That’s about where the similarities end, however. Preferreds have some quirks that separate them from bonds, making them attractive to investors.
What to know about preferred stock
Preferred stocks have special privileges that would never be found with bonds. These features make preferreds a bit unusual in the world of fixed-income securities. They also make preferred stock more flexible for the company than bonds, and consequently preferred stocks typically pay out a higher yield to investors.
Preferred stock is often perpetual. Bonds have a defined term from the start, but preferred stock typically does not. Unless the company calls — meaning repurchases — the preferred shares, they can remain outstanding indefinitely.
Preferred dividends can be postponed (and sometimes skipped entirely) without penalty. This feature is unique to preferred stock, and companies will make use of it if they’re unable to make a dividend payment. Cumulative preferred stocks may postpone the dividend but not skip it entirely — the company must pay the dividend at a later date. Noncumulative preferred stocks may skip paying the dividends completely without any legal penalty. However, this will make it difficult for the company to raise money in the future.
Preferred stock can be convertible. Some preferred stocks may give the holder the opportunity to convert or exchange their preferred shares into a specified number of shares of common stock at a specified price.
Preferred stock vs. common stock vs. bonds
Preferred stocks can make an attractive investment for those seeking steady income with a higher payout than they’d receive from common stock dividends or bonds. But they forgo the uncapped upside potential of common stocks and the safety of bonds.
A company usually issues preferred stock for many of the same reasons that it issues a bond, and investors like preferred stocks for similar reasons. For a company, preferred stock and bonds are convenient ways to raise money without issuing more costly common stock. Investors like preferred stock because this type of stock often pays a higher yield than the company’s bonds.
So if preferred stocks pay a higher dividend yield, why wouldn’t investors always buy them instead of bonds? The short answer is that preferred stock is riskier than bonds. Below, we explain the differences in each asset class in order of risk.
Bonds: For an investor, bonds are typically the safest way to invest in a publicly traded company. Legally, interest payments on bonds must be paid before any dividends on preferred or common stock. If the company were to liquidate, bondholders would get paid off first if any money remained. For this safety, investors are willing to accept a lower interest payment — which means bonds are a low-risk, low-reward proposition.
Preferred stock: Next in line is preferred stock. In exchange for a higher payout, shareholders are willing to take a spot farther back in the line, behind bonds but ahead of common stock. (Their preferred status over common stock is the origin of the name “preferred stock.”) Once bondholders receive their payouts, preferred holders may receive theirs. As noted above, sometimes a company can skip its dividend payouts, increasing risk. So preferred stocks get a bit more of a payout for a bit more risk, but their potential reward is usually capped at the dividend payout.
Common stock: Bringing up the rear are common stockholders, who will receive a payout only if the company is paying a dividend and everyone else in front of them has received their full payout. In the event of a company’s liquidation in bankruptcy, these stockholders get what’s left over after bondholders and preferred stockholders have been made whole. But unlike with bonds and preferreds, if the company is a success, there’s no upside cap on a common stockholder’s profits. The sky really is the limit.
How to buy preferred stock
Preferred stocks are traded on exchanges similar to common stocks, which provides pricing transparency. However, most companies do not issue preferred stock, so the total market for them is small and liquidity can be limited. The most common issuers of preferred stocks are banks, insurance companies, utilities and real estate investment trusts, or REITs.
Companies issuing preferreds may have more than one offering for you to vet. Often you may find several different offerings of preferreds from the same issuer but with different yields. Before purchasing preferreds, an investor can review the credit rating from Moody’s or S&P for each particular offering and take the rating into consideration along with other features, such as yields, callability or convertibility.
You can purchase preferreds in any brokerage account, but note that their ticker symbols will be different from their common stock counterpart. Make sure to verify all of the details to ensure you are purchasing the offering you want.
As with other stock and bond investments, an investor can reduce investment risk through diversification of the preferred stocks within their portfolio. One way to do this is by investing in preferreds through an ETF or mutual fund, which allows you to buy a collection of preferred stocks and minimize the risk associated with just one offering.
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