Preferred Stock—The Best Of Bonds And Equity In One Security
Preferred stock is a special type of stock that pays a set schedule of dividends and does not come with voting rights. Preferred stock combines aspects of both common stock and bonds in one security, including regular income and ownership in the company. Investors buy preferred stock to bolster their income and also get certain tax benefits.
How Preferred Stock Works
Preferred stock is often described as a hybrid security that has features of both common stock and bonds. It combines the stable and consistent income payments of bonds with the equity ownership advantages of common stock, including the potential for the shares to rise in value over time.
Preferred Stock vs Bonds
Preferred stock offers consistent and regular payments in the form of dividends, which resemble bond interest payments. Like bonds, shares of preferred stock are issued with a set face value, referred to as par value. Par value is used to calculate dividend payments and is unrelated to preferred stock’s trading share price.
Unlike bonds, preferred stock is not debt that must be repaid. Income from preferred stock gets preferential tax treatment, since qualified dividends may be taxed at a lower rate than bond interest.
Preferred stock dividends are not guaranteed, unlike most bond interest payments. If a company’s profits slump or it’s in the red and losing money, the company may choose to reduce or even end dividend payments. Common stock dividends are reduced or eliminated before preferred stock dividends, although even preferred stock dividends may be lowered or eliminated in certain cases.
Preferred stock’s priority ahead of common stock also extends to bankruptcy. If a company goes bankrupt and is liquidated, bondholders are repaid first from the remaining assets, followed by preferred shareholders. Common stockholders are last in line, although they’re usually wiped out in bankruptcy.
Common Stock vs Preferred Stock
Common stock and preferred stock both give the holders ownership of a company. You’re probably more familiar with common stock, which provides voting rights and may even pay dividends. Preferred stocks offer more regular, scheduled dividend payments, which may be appealing to some investors, but they may not provide the same voting rights or as much potential for growth in value over time.
With common stock, you have the potential for unlimited upside: There’s no limit to how high a stock price can go. With preferred stock, your gains are more limited. That’s because like bond prices, preferred stock prices change slowly and are tied to market interest rates.
Preferred stocks do provide more stability and less risk than common stocks, though. While not guaranteed, their dividend payments are prioritized over common stock dividends and may even be back paid if a company can’t afford them at any point in time. Preferred stockholders also come before common stockholders, but after bondholders, in receiving payment if a company goes bankrupt.
It’s also worth noting that preferred stocks are callable in a way common stocks aren’t. After a certain date, the company can recall preferred stock shares. This may be at the par value or at a slightly higher call price. Either of these may be different from the market price you paid for the preferred stock.
A company might recall and reissue a preferred stock to reduce the dividend payment to match current interest rates. Companies may also recall and reissue bonds for similar reasons.
Preferred Stock May Be Convertible To Common Stock
If you have preferred shares, one way to take advantage of a degree of capital appreciation is to convert them into common shares. Not every company offers convertible shares, but if the choice is available, you might be able to turn your preferred stock into common stock at a special rate called the conversation ratio.
Preferred Stock Conversion Ratio
For example, your preferred stock might have a conversion ratio of 5.5. If you decided to trade in a share of preferred stock, you’d get 5.5 shares of common stock.
Just because you can convert a preferred stock into common stock doesn’t mean it’ll be profitable, though. Before converting your preferred stock, you need to check the conversion price. To do that, divide the par value of the preferred stock by the conversion ratio. If the resulting number is not equal or higher than the current common share price, you will lose money converting your stock. This is called the conversion premium.
If you bought a preferred share for $75 in the example above, the conversion price would be $13.64 ($75 / 5.5). To see a capital gain from the conversion, the stock needs to be trading above that price. If it’s trading at $10 per share, your $75 share provides you $55 of common stock. In this case, the conversion premium is 20%, figured using this formula: [par value – (current common stock price x conversion ratio)] / 100.
You may also consider the loss of or difference in dividend income that comes with switching to common stock.
Trading Preferred Stock
Preferred stocks can be traded on the secondary market just like common stock. However, just because it can be sold doesn’t mean you’ll receive the same amount you paid for it. While preferred stock prices are more stable than common stock prices, they don’t always match par values.
In addition, convertible preferred stocks’ resale values may be tied to their conversion premiums. If preferred stock has a low premium (or no premium), its value may rise like its related common stock. If it has a high conversion premium, meaning it is not profitable to convert its shares, it may trade with pricing consistency similar to a bond.
Preferred Stock Dividends
Investors often choose preferred stocks for their regular dividend payments. Since 1900, preferred stocks have seen average annual returns of over 7%, most of which are from dividend payments. However, it’s important to note that, even though preferred shareholders are paid dividends before common shareholders, dividends aren’t necessarily guaranteed.
This is in contrast to bond interest payments. If a company is not willing or able to pay a dividend for a preferred stock in a given quarter, though, you may be eligible for back payment. That is determined by whether your preferred shares offer cumulative or noncumulative dividends.
Cumulative vs Noncumulative Dividends
Preferred stock dividends can be cumulative or noncumulative. With cumulative dividends, the company might pay the dividend at a later date if it can’t make dividend payments as scheduled. These dividends accumulate and are made later when the company can afford it.
Noncumulative dividends, on the other hand, can be missed without penalty. If a company decides that it can’t pay a dividend, it can choose to skip paying that dividend.
Before purchasing preferred shares, consider if you’re OK with missing dividend payments and recognize with noncumulative dividends, you might not receive any dividends at all.
Preferred Stock Dividend Yields
Dividend yield is a concept that helps you understand the relative value and return you get from preferred stock dividends. Par value is key to understanding preferred stock dividend yields.
Because preferred stocks’ par values are fixed and do not change, preferred stock dividend yields are more static and less variable than common stock dividend yields. You calculate a preferred stock’s dividend yield by dividing the annual dividend payment by the par value.
If a share of preferred stock has a par value of $100 and pays annual dividends of $5 per share, the dividend yield would be 5%.
Because par values are not the same as trading values, you have to pay attention to the trading price of preferred shares as well. If the preferred stock from the example above is trading at $110, its effective dividend yield would decrease to 4.5%.
Why Buy Preferred Stock?
Depending on your investment goals, preferred stock might be a good addition to your portfolio. Some of the main advantages of preferred stock include:
Higher dividends. In general, you can receive higher regular dividends with preferred shares. Payouts are also usually greater than what you’d receive with a bond because you’re assuming more risk.
Priority access to assets. If the company goes bankrupt, preferred shareholders are in line ahead of common shareholders, but still behind bondholders.
Potential premium from callable shares. Because preferred stock is callable, the company can buy it back. If the callable price is above the par value, you may receive more than you paid for the preferred stock.
Ability to convert preferred stock to common stock. When you buy convertible shares, you can trade in your preferred stock for common stock. If the value of the common stock drastically rises, you could convert your shares and benefit from its appreciation while investing in a less risky asset.
If you choose to invest in preferred shares, consider your overall portfolio goals. Preferred shares come with high dividend payments but limited growth potential, and they might be called back by a company with little or no notice. While preferred shares offer more dividend security than common stocks, dividends still are not guaranteed.
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Article initially appeared on forbes.com
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