Preferred Stock: What it Is, How it Works

What Is Preferred Stock?

The term “stock” refers to ownership or equity in a firm. There are two types of equity: common stock and preferred stock. Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. The details of each preferred stock depend on the issue. 

Understanding Preferred Stock

Preferred shareholders have priority over common stockholders when it comes to dividends, which generally yield more than common stock and can be paid monthly or quarterly. These dividends can be fixed or set in terms of a benchmark interest rate like the London Interbank Offered Rate (LIBOR)​, and are often quoted as a percentage in the issuing description.

Adjustable-rate shares specify certain factors that influence the dividend yield, and participating shares can pay additional dividends that are reckoned in terms of common stock dividends or the company’s profits. The decision to pay the dividend is at the discretion of a company’s board of directors.

Unlike common stockholders, preferred stockholders have limited rights, which usually does not include voting. Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price. This appeals to investors seeking stability in potential future cash flows.

Types of Preferred Stock

All of the types of preferred stock are exactly that—preferred stock. However, not all preferred stocks are the same. Each may or may not have different features that make them more or less favorable compared to other types.

Prior Preferred Stock

Prior preferred stock refers to the order in which preferred stock is ranked when considered for prioritization for creditors or dividend awards. Though regular preferred stock and prior preferred stock both hold precedence over common stock, prior preferred stock refers to an earlier issuance of preferred stock that takes priority. For example, if a company can only financially afford to pay one tier of shares its dividend, it must start with its prior preferred stock issuance.

Preference Preferred Stock

Preference preferred stock is considered the next tier of stock in terms of prioritization. Though it falls behind prior preferred stock, preference preferred stock often has greater priority compared to other issuances of preferred stock. If there are multiple tiers of preference preferred stock, each issuance is usually given its rank (i.e., most senior, second senior, etc.).

Perpetual Preferred Stock

Some types of preferred stock have a fixed end date in which, much like a bond, the original capital contributed is returned to shareholders. In most cases, preferred stock is considered perpetual. This means that the initial capital invested will not be returned. An investor must sell their shares at their choosing to redeem the shares.

Convertible Preferred Stock

In most cases, convertible preferred stock allows a shareholder to trade their preferred stock for common stock shares. The exchange may happen when the investor wants, regardless of the price of either share. Once the exchange has occurred, the investor has relinquished its right to trade and cannot convert the common shares back to preferred shares. Convertible preferred stock usually has predefined guidance on how many shares of common stock it can be exchanged for.

Cumulative Preferred Stock

If a company issues a dividend, it may issue cumulative preferred stock. This means that should a company issue a dividend but not actually pay it out, that unpaid dividend is accumulated and must be made in a future period. It is also important to note that preferred stock takes precedence over common stock for receiving dividend payments. This means that a share of cumulative preferred stock must have all accumulated dividends from all prior years paid before any other lower-tier share can receive dividend payments.

Noncumulative Preferred Stock

It’s worth pointing out that some preferred stock may explicitly state that it is noncumulative. This means that if a company does not pay a dividend in a given year, that “missed” dividend is not directly made up for in a future period. Dividends are treated as year-to-year; any prior period does not carry over and does not hold weight into the order of who gets paid what. This type of stock is common in banking, as there are international rules that dictate how certain capital is classified by regulators.

Participating Preferred Stock

In some years, a company may decide it cannot financially afford to issue a dividend. However, participating preferred stockholders may still be entitled to a dividend. These participating dividends may be tied to company achievements such as total sales, earnings, or specific margins. A participating preferred stockholder may also earn these types of dividends on top of what the company issues as “normal dividends,” assuming the company has enough finances to make all payments.

Preferred Stock vs. Common Stock

While preferred stock and common stock are both equity instruments, they share important distinctions. First, preferred stock receive a fixed dividend as dividend obligations to preferred shareholders must be satisfied first. Common stockholders, on the other hand, may not always receive a dividend. A company may fully pay all dividends (even prior years) to preferred stockholders before any dividends can be issued to common stockholders.

Second, preferred stock typically do not share in the price appreciation (or depreciation) to the same degree as common stock. The inherent value of preferred stock is the ongoing cash proceeds that investors receive. Common stock, on the other hand, are more difficult to value. However, because they are not tied to semi-fixed payments, investors hold common stock for the potential capital appreciation.

Lastly, the two types of equity have different terms or conditions. Preferred stockholders typically have no voting rights, whereas common stockholders do. Preferred stockholders may have the option to convert shares to common shares, but not vice versa. Preferred shares may be callable where the company can demand to repurchase them at par value. Preferred stock also receives better treatment during liquidations.

Preferred Stock vs. Bonds

Preferred stock is often compared to bonds because both may offer recurring cash distributions. However, as there are many differences between stocks and bonds, there are differences with preferred equity as well.

In terms of similarities, both securities are often issued at face value or par value. This value is used to calculate future dividend payments and is unrelated to the market price of the security. Then, companies may issue dividends similar to how bonds issue coupon payments. Though the mechanism is different, the end result is ongoing payments derived from an investment.

There are still many differences between the two. Preferred stock dividend payments are not fixed and can change or be stopped. However, these payments are often taxed at a lower rate than bond interest. In addition, bonds often have a term that matures after a certain amount of time. There is, theoretically, no “end date” to preferred stock.

In addition, there are considerations to make regarding the order of rights should a company be liquidated. In most cases, debtholders receive preferential treatment, and bondholders receive proceeds from liquidated assets. Then, preferred shareholders receive distributions if any assets remain. Common stockholders are last in line and often receive minimal or no bankruptcy proceeds.

Companies in Distress

If a company is struggling and has to suspend its dividend, preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders. Shares that have this arrangement are known as cumulative. If a company has multiple simultaneous issues of preferred stock, these may in turn be ranked in terms of priority. The highest ranking is called prior, followed by first preference, second preference, etc.

Preferred shareholders have a prior claim on a company’s assets if it is liquidated, though they remain subordinate to bondholders. Preferred shares are equity, but in many ways, they are hybrid assets that lie between stock and bonds. They offer more predictable income than common stock and are rated by the major credit rating agencies.

Unlike bondholders, failing to pay a dividend to preferred shareholders does not mean a company is in default. Because preferred shareholders do not enjoy the same guarantees as creditors, the ratings on preferred shares are generally lower than the same issuer’s bonds, with the yields being accordingly higher.

Voting Rights, Calling, and Convertibility

Preferred shares usually do not carry voting rights, although under some agreements, these rights may revert to shareholders who have not received their dividend. 

Preferred shares have less potential to appreciate in price than common stock, and they usually trade within a few dollars of their issue price, most commonly $25. Whether they trade at a discount or premium to the issue price depends on the company’s creditworthiness and the specifics of the issue—for example, whether the shares are cumulative, their priority relative to other issues, and whether they are callable.

If shares are callable, the issuer can purchase them back at par value after a set date. If interest rates fall, for example, and the dividend yield does not have to be as high to be attractive, the company may call its shares and issue another series with a lower yield. Shares can continue to trade past their call date if the company does not exercise this option.

Some preferred stock are convertible, meaning they can be exchanged for a given number of common shares under certain circumstances. The board of directors might vote to convert the stock, the investor might have the option to convert, or the stock might have a specified date when it automatically converts. Whether this is advantageous to the investor depends on the market price of the common stock.

Typical Buyers of Preferred Stock

Preferred stock come in a wide variety of forms and are generally purchased through online stockbrokers by individual investors. The features described above are only the more common examples, and these are frequently combined in a number of ways. A company can issue preferred shares under almost any set of terms, assuming they don’t fall afoul of laws or regulations. Most preferred issues have no maturity dates or have very distant ones.

Institutions are usually the most common purchasers of preferred stock, especially during the primary distribution phase. This is due to certain tax advantages that are available to them but that are not available to individual investors. Because these institutions buy in bulk, preferred issues are a relatively simple way to raise large amounts of capital. Private or pre-public companies issue preferred stock for this reason.

Preferred stock issuers tend to group near the upper and lower limits of the creditworthiness spectrum. Some issue preferred shares because regulations prohibit them from taking on any more debt or because they risk being downgraded. On the other hand, several established names like General Electric, Bank of America, and Georgia Power issue preferred stock to finance projects.

The Bottom Line

Investors interested in generating cash flow from their equity holdings may be better suited holding preferred equity or preferred stock. This type of equity investment represents ownership of a company and results in prioritized treatment for dividend distributions. Though there are sacrifices for this right, preferred stock are simply a different vehicle for owning part of a business.