How Does Preferred Stock Work?

Within the spectrum of financial instruments, preferred stocks (or "preferreds") occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments.

Preferred stocks are sometimes called hybrid securities. In this article, we look at preferred shares and compare them to some better-known investment vehicles.

Understanding Preferred Stocks

A company may choose to issue preferreds for a couple of reasons:

• Flexibility of payments. Preferred dividends may be suspended in case of corporate cash problems.
• Easier to market. Preferred stock is typically bought and held by institutional investors, which may make it easier to market during an initial public offering.

Preferred stock is attractive as it usually offers higher fixed-income payments than bonds with a lower investment per share. Preferred stockholders also have a priority claim over common stocks for dividend payments and liquidation proceeds. Its price is usually more stable than common stock. Furthermore, it is more liquid than corporate bonds of similar quality.

Preferred stock often has a callable feature that allows the issuing corporation to forcibly cancel the outstanding shares for cash. This precludes the investor from participating in any future price appreciation. It also doesn't specify the maturity date which injects uncertainty over the recovery of invested principal. There is limited appreciation potential, no voting rights and it is sensitive to interest rates.

Rules from the Internal Revenue Service (IRS) make it attractive for institutions to invest in preferred stock. Under what is known as the dividend received deduction, a U.S. corporation receiving dividends from a domestic company may deduct up to 50% of the income from its taxes if it owns less than 20% of the dividend payer. If the corporation owns more than 20% of the dividend payer, it can deduct 65%.

However, the fact that individuals are not eligible for such favorable tax treatment should not exclude preferreds from consideration as a viable investment.

Types of Preferred Stock

Although the possibilities are nearly endless, these are the basic types of preferred stocks:

• Cumulative. Most preferred stock is cumulative, meaning if the company withholds part or all of the expected dividends, they are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative preferred.
• Callable. Most preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus.
• Convertible. The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus.
• Participating. This is preferred stock that has a fixed dividend rate. If the company issues participating preferreds, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating.
• Adjustable-Rate Preferred Stock (ARPS). These preferreds pay dividends based on several factors stipulated by the company. Dividends for ARPS are keyed to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets.

Bonds and Preferreds

Because preferred shares are often compared with bonds and other debt instruments, let's look at their similarities and differences.

Similarities

Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par, usually at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares falls. If rates decline, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds.

Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds—a company calls in securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability.

Like bonds, preferreds are senior to common stock. However, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much.

As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock.

Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.

Differences

As observed earlier, preferred stock is equity while bonds are debt. Most debt instruments, along with most creditors, are senior to any equity.

Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends.

The trust indenture prevents companies from taking the same action on their corporate bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for a company to issue and pay dividends on preferred stocks.

Computing current yields on preferreds is similar to the calculation on bonds where the annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75 ÷ $25 = .07, or 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors.

While preferreds are interest-rate sensitive, they are not as price-sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds.

Information about a company's preferred shares is easier to obtain than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier, because bonds (with par values around $1,000) often have minimum purchase requirements.

Common Stock and Preferred Stock

Similarities

Both are equity instruments. Their dividends come from the company's after-tax profits and are taxable to the shareholder (unless held in a tax-advantaged account).

Differences

Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied.

This is where preferreds lose their luster for many investors. If, for example, a pharmaceutical research company discovers an effective cure for the flu, its common stock will soar, while the preferreds might only increase by a few points. The lower volatility of preferred stocks may look attractive, but it cuts both ways: Preferreds aren't as sensitive to a company's losses, but they will not share in a company's success to the same degree as common stock.

Whereas common stock is often called voting equity, preferred stocks usually have no voting rights.

The Bottom Line

An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. The starting point for research on a specific preferred is the stock's prospectus, which you can often find online. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market.