What are preferred stock?

The world of investing is often divided into two primary camps: stocks and bonds. Stocks offer growth and ownership, while bonds provide steady income and safety. But what if there was an asset class that lived right in the middle? Enter Preferred Stock.

Often referred to as a “hybrid security,” preferred stock combines the features of both equity and debt. For the layperson, it can be a confusing concept. Is it a stock? Is it a bond? Why is it called “preferred”? In this comprehensive guide, we will peel back the layers of this unique financial instrument to help you decide if it has a place in your portfolio.

What Are Preferred Stocks? Defining the Hybrid Investment

At its most basic level, preferred stock is a type of equity ownership in a corporation. However, it functions very differently from the “common stock” most people are familiar with. When you buy shares of a company like Apple or Amazon on a standard brokerage app, you are typically buying common stock.

Preferred stock is “preferred” because it sits higher in the company’s capital structure. This means preferred shareholders have a higher claim on the company’s assets and earnings than common shareholders. If a company makes a profit, preferred stockholders get their dividends first. If a company goes bankrupt, preferred stockholders are paid out before common stockholders (though still after bondholders).

The “Hybrid” Nature Explained

To understand preferred stock, think of it as a bridge:

• Like a Stock: It represents ownership, is issued by a corporation, and can appreciate in value.

• Like a Bond: It usually pays a fixed dividend (similar to interest), has a “par value,” and is highly sensitive to interest rate changes.

Common Stock vs. Preferred Stock: The Key Differences You Must Know

For a beginner, the distinction between “Common” and “Preferred” can seem like a matter of prestige, but it is actually a matter of legal rights and financial structure.

1. Voting Rights

This is the biggest trade-off. Common shareholders usually have voting rights; they can vote on board members and corporate policy. Preferred shareholders typically have no voting rights. You are essentially a silent partner—you provide the capital and get a check in return, but you don’t get a say in how the company is run.

2. Dividend Consistency

Common stock dividends are never guaranteed. A company can cut them at any time to save cash. Preferred stock dividends, however, are usually fixed and contractual. They act more like a steady stream of income, making them a favorite for retirees or those seeking “yield.”

3. Price Volatility

Common stocks are the “wild horses” of the market—their prices can swing wildly based on news, earnings, or hype. Preferred stocks are much calmer. Since their value is tied largely to their fixed dividend, they tend to trade near their “par value” (usually $25 or $100). They won’t usually “to the moon,” but they won’t usually crash as hard as common shares during a typical market dip.

Why Do Investors Choose Preferred Shares? The Benefits of “Going Preferred”

If preferred stock doesn’t offer the massive growth potential of common stock, why would anyone buy it? The answer lies in the unique balance of risk and reward.

High Yield Potential

In a low-interest-rate environment, bank savings accounts and government bonds might offer measly returns. Preferred stocks often offer much higher dividend yields, sometimes ranging from 5% to 8%. For an investor looking to generate monthly or quarterly income, this is incredibly attractive.

Safety in the Pecking Order

As mentioned, preferred stockholders have “priority.” If a company faces a financial crunch and can only afford to pay some of its investors, the preferred shareholders are legally required to be paid before a single cent goes to common stockholders. This provides a “buffer” that common stock lacks.

Price Stability

Because preferred stocks act more like fixed-income instruments, their prices are relatively stable. This makes them a great tool for capital preservation. If you have a large sum of money and you want it to earn more than a savings account but you’re too afraid of a 40% market crash, preferred stocks can be a middle-ground solution.

The Hidden Risks: What the Brochures Won’t Tell You

No investment is without risk. While preferred stock is “safer” than common stock in some ways, it carries specific risks that can catch a layperson off guard.

1. Interest Rate Risk

This is the “Bond-like” curse. Since preferred stocks pay a fixed dividend, their value is inversely related to interest rates.

• When interest rates rise: New bonds and savings accounts start offering better returns. Your fixed 5% preferred dividend looks less attractive, so people sell their shares, and the price of the stock drops.

• When interest rates fall: Your $5\%$ dividend looks amazing compared to the 1% bank rate, so people buy the stock, and the price goes up.

2. Inflation Risk

Because the dividend is fixed, it doesn’t “grow” with the company. If inflation spikes to 7% and your preferred stock only pays 5%, you are effectively losing purchasing power every year. Common stocks can often raise their prices and profits during inflation, but preferred stocks are stuck with their original deal.

3. Callability (The “Take-Back” Clause)

Most preferred stocks are “callable.” This means the company has the right to buy the shares back from you at par value after a certain date (usually five years after issuance). Companies usually do this if interest rates have dropped, allowing them to issue new preferred stock at a lower rate. This can leave investors with a pile of cash and nowhere to reinvest it for the same high return.

Understanding Dividend Structures: Cumulative vs. Non-Cumulative

Not all preferred dividends are created equal. When reading a prospectus, you must look for these two terms, as they drastically change your level of protection.

Cumulative Preferred Stock

This is the gold standard for investors. If a company hits a rough patch and “skips” a dividend payment, they don’t just disappear. They accumulate in a “bucket.” The company is legally forbidden from paying any dividends to common shareholders until all the “back-owed” (arrears) dividends are paid to the cumulative preferred holders.

Non-Cumulative Preferred Stock

If the company skips a dividend, it’s gone forever. You have no legal right to claim that lost income later. This is much riskier for the investor and is most common in the banking sector.

Special Types of Preferred Stock: Beyond the Basics

To hit that advanced SEO ranking, we need to look at the specialized versions of these shares that professional traders use.

1. Convertible Preferred Stock

These shares give the investor the option to convert their preferred shares into a fixed number of common shares. This is the “best of both worlds.” You get the steady, high dividends of preferred stock, but if the company’s common stock suddenly sky-rockets (like a tech startup), you can flip your shares into common stock and ride the wave.

2. Participating Preferred Stock

Most preferred stock only pays a fixed dividend. “Participating” shares give you the fixed dividend plus a share of the extra profits if the company has an exceptionally good year. These are rare and usually reserved for venture capital deals.

3. Adjustable-Rate Preferred Stock (ARPS)

These dividends aren’t fixed. They are tied to a benchmark, like the T-bill rate. This protects the investor from interest rate risk because as rates go up, your dividend goes up too.

The Issuer’s Perspective: Why Do Companies Issue Preferred Stock?

You might wonder: “If companies have to pay a high, fixed dividend, why don’t they just issue bonds or common stock?”

1. Debt-to-Equity Ratio: On a balance sheet, preferred stock is usually counted as “equity,” not “debt.” This makes the company look healthier to banks and credit rating agencies.

2. No Ownership Dilution: Since preferred shares don’t have voting rights, the founders and current board members don’t have to worry about a “hostile takeover” or losing control of the company.

3. Flexibility: Unlike bond interest, which must be paid to avoid default, skipping a preferred dividend does not automatically trigger bankruptcy. This gives the company a “safety valve” during a crisis.

Tax Considerations: The “Qualified Dividend” Advantage

In the United States, preferred stock dividends often enjoy a significant tax advantage over bond interest.

• Bond Interest: Usually taxed as “ordinary income,” which can be as high as 37%.

• Preferred Dividends: If they are “qualified dividends,” they are taxed at the much lower capital gains rate (usually 0%, 15%, or 20%, depending on your income).

For an investor in a high tax bracket, a 5% preferred dividend might actually put more money in your pocket than a 6% bond interest payment after taxes are calculated.

How to Invest in Preferred Stocks: Individual Shares vs. ETFs

How do you actually buy these things? You won’t find them under the usual tickers like “AAPL.” They often have complicated symbols like “PFE-PR-A” or “C.PR.N.”

Option A: Buying Individual Shares

This requires significant research. You need to read the prospectus, check the “call date,” and see if the dividend is cumulative. This is best for advanced investors who want to “cherry-pick” the best yields.

Option B: Preferred Stock ETFs (Recommended for Beginners)

The easiest way is to buy an Exchange-Traded Fund (ETF) that holds hundreds of different preferred stocks. This provides instant diversification.

• Pros: Easy to trade, diversified, professionally managed.

• Cons: You have to pay a small management fee (expense ratio).

• Popular Examples: The iShares Preferred and Income Securities ETF (PFF) is one of the most well-known in the U.S. market.

When Should You Add Preferred Stocks to Your Portfolio?

Preferred stocks are not a “set it and forget it” solution for everyone. They fit specific needs:

• For Retirees: If you need a steady check every month to pay for groceries and travel, the high yields of preferred stock are excellent.

• For Diversification: If your portfolio is 100% common stocks, adding preferreds can lower your overall volatility.

• For High-Net-Worth Individuals: The tax advantages of qualified dividends make them a superior choice for taxable brokerage accounts.

Common Myths and Misconceptions

Let’s clear up some of the “fake news” surrounding preferred equities.

Myth #1: “Preferred stock is as safe as a bond.”

False. In a bankruptcy, bondholders are paid first. If a company goes under, preferred stockholders often get pennies on the dollar or nothing at all.

Myth #2: “The price will never go down.”

False. As we saw, if interest rates jump from 2% to 5%, the price of older preferred stocks will drop significantly.

Myth #3: “I own the company, so I can vote.”

False. Unless it’s a very specific and rare type of share, you are a silent investor with zero voting power.

The “Middle Way” of Investing

Preferred stocks are a powerful, if often overlooked, tool in the investor’s toolkit. They offer a unique sanctuary for those who are tired of the measly returns of savings accounts but are too risk-averse for the “casino” feel of high-growth common stocks.

By understanding the hierarchy of claims, the impact of interest rates, and the importance of cumulative dividends, you can use preferred shares to build a more resilient, high-yielding portfolio. As with any investment, the key is balance. Preferred stock shouldn’t be your entire portfolio, but for many, it is the perfect “secret sauce” to enhance income and stability.