What is Preferred Stock?
A majority of retail investors gravitate towards common stock when looking to invest in a company, but there is another little known option called preferred stock that might be worth considering! Our aim with this post is to introduce you to how preferred stock works, how it differs from common stock and some reasons why you might consider buying preferred stock.
Let’s get started!
How Does Preferred Stock Work?
Preferred stock is often referred to as hybrid security because its structure resembles characteristics similar to both stocks and bonds.
Companies prefer to use bonds and preferred stocks to raise money without having to issue more costly common shares. As it relates to a company’s capital structure, preferred stocks rank between equity and debt meaning that they are more senior than common stock but more junior than bonds!
While preferred stocks are considered to be equity, they are typically issued with a face value and payout steady dividends based on a percentage of the fixed face value.
The market value of preferred stocks tends to rise in price when interest rates fall and fall when interest rates rise meaning that they are sensitive to interest rates.
A majority of preferred stock is redeemable or “callable” meaning that the issuer ( the company) has the right to redeem the stock at dates and prices provided in the preferred stock’s prospectus. That being said, if there is no maturity date provided by the issuer, then the shares can remain outstanding indefinitely.
Most preferred stocks have no voting rights associated with them, however, they may be convertible and give the holder the opportunity to convert the preferred shares into a specified number of common shares at a specified price.
Something interesting to note is that preferred dividends can be postponed or skipped entirely by the issuing company, which provides some additional risk that investors should consider.
The Differences between Common vs Preferred Stock
Dividends: Dividends payout tends to be higher for preferred stocks over common stock; preferred shareholders are often paid a fixed dividend whereas common stockholders have variable dividends declared by the board of directors and never guaranteed.
Performance: Common stock provides the largest potential for long-term growth because the market value of the common stock is based on demand and supply from market participants, whereas the face value of the preferred stock is issued by the company and generally does not experience much volatility unless interest rates change.
Voting Rights: Preferred stock comes with no voting rights associated with them, whereas common stock provides the stockholder with the ability to vote to elect the board members that make the major decisions for the company!
Claim to Assets: Preferred shareholders have priority over a company’s income and are considered more senior than common shareholders so they are so they will be paid dividends before common shareholders. In the event that a company files for bankruptcy, preferred shareholders will be paid out before common stockholders after creditors and bondholders are made whole.
Convertibility: Sometimes preferred stock can be converted to a fixed number of common stock, however, the common stock does not have this benefit!
Certainty: If the company does not make any excess profits then the common stockholders may not receive any dividends, whereas a preferred stockholder will still receive dividends even if the company incurs losses
Why Would You Buy Preferred Stock?
A majority of preferred stockholders are institutional investors, however, preferred stock can still be an attractive investment for income investors for the following reasons:
- Seeking steady income with a higher dividend payout than common stock and bonds.
- Potentially favorable tax treatment depending on your local jurisdiction (consult with your local accountant for more information)
- Portfolio diversification – Preferred stocks have a low correlation with equities and bonds.
How to Buy Preferred Stock
Preferred stocks are traded on exchanges which means that you can purchase them in any brokerage account.
The market for preferred shares is a bit smaller and less liquid than the market for common stocks because there are a limited number of companies that actually issue preferred shares.
The companies that do offer preferred stocks (usually banks, insurance companies, and/or REITS) usually have several different offerings with different yields that an investor can choose from.
Before considering purchasing a specific preferred stock offering, we would always recommend that you complete your due diligence by reviewing the credit rating (available to Moody’s or S&P) and taking into account some additional features such as the dividend yield, convertibility, and callability of each offer.
While common stock gets all of the attention because of the long-term growth potential, an investor looking for relatively safe returns might consider preferred stock instead! If you are planning on adding some preferred stock to your portfolio, we encourage you to complete your due diligence by referencing the stock’s prospectus and carefully weighing the advantages and drawbacks.
Before considering trading stocks after-hours, we encourage traders to practice and build confidence and consistency in their trading strategy during regular market hours!
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.