What Is a 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. 

KEY TAKEAWAYS

 Preferred stockholders have a higher claim on distributions (e.g.

dividends) than common stockholders.
 Preferred stockholders usually have no or limited, voting rights in
corporate governance.1
 In the event of a liquidation, preferred stockholders' claim on assets
is greater than common stockholders but less than bondholders. 2
 Preferred stock has characteristics of both bonds and common stock
which enhances its appeal to certain investors.
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What Is The Difference Between Preferred Stock And Common Stock?

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. 1 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. 1 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.

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. 1  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. 2

Voting Rights, Calling, and Convertibility

Preferred shares usually do not carry voting rights, although under some
agreements these rights may revert to shareholders that have not received
their dividend.1  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.2
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. 2

Some preferred stock is convertible, meaning it can be exchanged for a

given number of common shares under certain circumstances. 2  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 at which 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 comes in a wide variety of forms and is 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
foul of laws or regulations. Most preferred issues have no maturity dates or
very distant ones.2

Institutions are usually the most common purchasers of preferred stock.

This is due to certain tax advantages that are available to them, but which
are not available to individual investors. 3  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
credit-worthiness spectrum. Some issue preferred shares because
regulations prohibit them from taking on any more debt, or because they
risk being downgraded. While preferred stock is technically equity, it is
similar in many ways to a bond issue; One type, known as trust preferred
stock, can act as debt from a tax perspective and common stock on the
balance sheet.4  On the other hand, several established names like
General Electric, Bank of America, and Georgia Power issue preferred
stock to finance projects.56 7

What Are the Advantages of a Preferred Stock?

A preferred stock is a class of stock that is granted certain rights that differ
from common stock. Namely, preferred stock often possesses higher
dividend payments, and a higher claim to assets in the event of liquidation.
In addition, preferred stock can have a callable feature, which means that
the issuer has the right to redeem the shares at a predetermined price and
date as indicated in the prospectus. In many ways, preferred stock shares
similar characteristics to bonds, and because of this are sometimes
referred to as hybrid securities. 

What Is the Difference Between a Preferred Stock and a Common Stock?

While preferred stock and common stock are both equity instruments, they
share important distinctions. First, preferreds 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. Secondly, preferreds typically do not share in the price
appreciation (or depreciation) to the same degree as common stock.
Lastly, preferred typically have no voting rights, whereas common
stockholders do.

What Is an Example of a Preferred Stock?

Consider a company is issuing a 7% preferred stock at a $1,000 par value.

In turn, the investor would receive a $70 annual dividend, or $17.50
quarterly. Typically, this preferred stock will trade around its par value,
behaving more similarly to a bond. Investors who are looking to generate
income may choose to invest in this security. The most common sector
that issues preferred stock is the financial sector, where preferred stock
may be issued as a means to raise capital.