Introduction
When most investors talk about buying stock in a company, they are almost always referring to “common stock.” This is the type of share that represents a slice of ownership in a business and typically comes with the right to vote on company matters. It is the most well-known type of equity investment. However, there is another, less-known class of stock that companies sometimes issue. This special class has a unique set of characteristics that blend the features of both a stock and a bond.
This asset is called preferred stock. It is a hybrid security that can be a powerful tool, especially for investors who are focused on generating income. However, its unique features can also be confusing for beginners. This guide will clearly define what preferred stock is. We will also explain how its dividend payments work. In addition, we will compare it directly to both common stock and bonds. Finally, we will explore its key features and help you understand who might consider it for their investment portfolio.
Defining Preferred Stock: A Stock-Bond Hybrid
First, let’s establish a clear definition. Preferred stock is a class of ownership in a corporation. It has a higher claim on the company’s assets and its earnings than common stock does. The name “preferred” comes directly from this fact. These shareholders receive preferential treatment over common shareholders in a couple of key areas.
Preferred stock is often called a hybrid security. This is because it has features that are similar to both stocks and bonds.
- Like a stock, it represents an ownership stake in the company. It is also bought and sold on a stock exchange, and its price can fluctuate.
- Like a bond, it typically pays a fixed, regular income payment (a dividend). Furthermore, preferred shareholders usually do not have any voting rights in the company.
To understand its place, think of a company’s capital structure as a line of people waiting to get paid if the company faces financial trouble.
- Bondholders are at the very front of the line. They are the company’s lenders, and they have the first legal claim on the company’s assets.
- Common stockholders are at the very back of the line. They are the ultimate owners of the company, and they only get whatever is left over after everyone else has been paid.
- Preferred stockholders stand in the middle. They are right between the bondholders and the common stockholders. This means they have a more secure position and a higher claim on assets than common stockholders, but a less secure position than the company’s bondholders.
The Key Feature: The Fixed Dividend
The most defining and attractive feature of preferred stock is that it typically pays a fixed, regular dividend. This dividend is a specific, predetermined amount. It is usually stated as a percentage of the stock’s “par value,” which is its face value at the time it was issued.
This dividend payment has priority. A company is required to pay all of its promised dividends to its preferred shareholders before it is allowed to pay any dividends at all to its common shareholders. This makes the dividend from a preferred stock much more secure and predictable than the variable dividend from a common stock.
It is also important to understand the difference between the two main types of preferred stock dividends:
- Cumulative Preferred Stock: This is the most common and investor-friendly type. If a company is struggling financially and decides to skip a dividend payment, this feature requires the company to pay all of its missed dividends to its preferred shareholders in the future. The company must do this before it can ever resume paying dividends to its common shareholders.
- Non-Cumulative Preferred Stock: With this type, any dividend payments that the company misses are gone forever. The investor has no right to claim them in the future.
Because of this steady and predictable dividend payment, preferred stock is a very popular asset for investors who are seeking to generate a reliable stream of income from their investment portfolio.
Preferred Stock vs. Common Stock vs. Bonds: A Comparison
To fully understand preferred stock, it is helpful to compare it directly to the two major asset classes it resembles.
- Ownership and Voting Rights
- Common Stock: Represents ownership and includes voting rights.
- Preferred Stock: Represents ownership but typically has no voting rights.
- Bonds: Represents debt. Bondholders are lenders, not owners, and have no voting rights.
- Income Payments
- Common Stock: Dividends are variable and are not guaranteed. The company’s board can increase, decrease, or eliminate them at any time.
- Preferred Stock: Dividends are typically fixed and have payment priority over common stock dividends.
- Bonds: Interest payments are a legal obligation of the company and are fixed.
- Risk and Position in Bankruptcy
- Common Stock: Highest risk. Common stockholders are paid last in a bankruptcy, and often receive nothing.
- Preferred Stock: Medium risk. Preferred stockholders are paid after bondholders but before common stockholders.
- Bonds: Lowest risk. Bondholders are creditors and are paid first.
- Potential for Price Appreciation
- Common Stock: Has the highest potential for price growth. Its value can increase dramatically as the company succeeds.
- Preferred Stock: Has lower potential for price appreciation. Its price tends to be more stable and behaves more like a bond, trading around its par value.
- Bonds: Have very low potential for appreciation. Their value is primarily tied to changes in market interest rates.
Other Important Features of Preferred Stock
In addition to the main characteristics, there are a few other common features you should be aware of.
- Callable Preferred Stock: This feature gives the issuing company the right to “call,” or buy back, the preferred stock from investors at a specified price after a certain date. A company might choose to do this if market interest rates fall, allowing it to issue new preferred stock at a lower dividend rate.
- Convertible Preferred Stock: This feature gives the investor the option to convert their preferred shares into a certain number of the company’s common shares. This offers the safety of the fixed dividend, but also gives the investor the potential to participate in the high growth of the common stock if the company performs exceptionally well.
Conclusion
In summary, preferred stock occupies a unique and important niche in the world of investing. It is a true hybrid security. It blends the ownership and market-traded nature of a stock with the steady, fixed-income characteristics of a bond.
It offers investors a dividend that is typically higher and more secure than the dividend from a common stock. It also provides a higher claim on a company’s assets in the event of financial trouble. In exchange for this greater safety and income, preferred shareholders usually give up their voting rights. They also forgo the high potential for capital appreciation that makes common stock so attractive to growth investors. For income-focused investors who are looking for a return that is higher than what bonds typically offer, but with less volatility than common stocks, preferred stock can be a valuable addition to a well-diversified portfolio.