Preferred Stock
Key Takeaways
- Preferred stock pays a fixed dividend and has priority over common stock in liquidation
- Preferred shareholders typically do not have voting rights in corporate matters
- Preferred stock behaves like a hybrid between bonds and common stock
- Types include cumulative, convertible, callable, and participating preferred stock
Definition
Preferred stock is a class of equity that gives holders a higher claim on assets and earnings than common stock. Preferred shareholders receive a fixed dividend payment, typically expressed as a percentage of the par value, before any dividends are paid to common stockholders.
Unlike common stock, preferred shares generally do not carry voting rights. This makes preferred stock a hybrid security that shares characteristics with both equities and bonds. The fixed dividend resembles a bond coupon, while the equity classification means preferred stock sits below debt in the capital structure.
There are several types of preferred stock. Cumulative preferred stock accumulates unpaid dividends that must be paid before common dividends resume. Convertible preferred stock can be exchanged for a specified number of common shares. Callable preferred stock can be redeemed by the issuing company at a set price after a certain date.
How It Works
When a company issues preferred stock, it sets a par value and a dividend rate. For example, a $100 par value preferred stock with a 5% dividend rate pays $5 per share annually. These dividends are typically paid quarterly and take priority over common stock dividends.
Preferred stock prices are sensitive to interest rate changes, similar to bonds. When interest rates rise, preferred stock prices tend to fall because the fixed dividend becomes less attractive compared to new issues offering higher yields. Conversely, falling rates tend to push preferred stock prices higher.
In a liquidation event, preferred stockholders are paid after bondholders and other creditors but before common stockholders. This intermediate position in the capital structure gives preferred stock a moderate risk profile. Many income-focused investors use preferred stocks to generate steady cash flow with less volatility than common stocks.
Example
Suppose Bank of America (BAC) issues Series L preferred stock with a $25 par value and a 6% annual dividend rate. Each share pays $1.50 per year ($25 × 6%), distributed quarterly at $0.375 per share. If you buy 400 shares at $25 each, investing $10,000, you receive $600 per year in preferred dividends. If Bank of America faces financial difficulty, your preferred dividends must be paid before any common stock dividends. However, if the common stock price doubles, your preferred shares will likely see only modest appreciation since the fixed dividend limits the upside.
Why It Matters
Preferred stock plays an important role in portfolio construction for income-seeking investors. The fixed dividend provides predictable cash flow, making preferred shares attractive to retirees and conservative investors who prioritize income over growth. Preferred stock yields are often higher than bond yields from the same issuer.
For companies, issuing preferred stock is a way to raise capital without diluting common stockholder voting power or taking on debt obligations. Banks and financial institutions are particularly active issuers of preferred stock because it can count toward regulatory capital requirements.
Advantages
- Fixed dividends provide predictable and often higher income than common stock
- Priority over common stock for dividend payments and liquidation claims
- Less price volatility than common stock in most market conditions
- Convertible preferred stock offers potential for capital appreciation
Limitations
- Limited upside potential compared to common stock appreciation
- Typically no voting rights in corporate governance decisions
- Sensitive to interest rate changes, similar to bonds
- Callable preferred stock can be redeemed by the issuer, ending income stream
Frequently Asked Questions
Related Terms
Browse more definitions in the financial terms glossary.