Preferred Stock

Preferred stock is a class of corporate equity that combines features of a stock and a bond. Like a bond, it pays a fixed, stated dividend and its price is driven mostly by interest rates; like a stock, it is an ownership interest that sits below the company's creditors. Its defining trait is priority: preferred shareholders must be paid their dividend before any dividend goes to common stockholders, and they stand ahead of common stockholders (though behind bondholders and other creditors) if the company is wound up. In return for that priority, preferred stock usually carries no voting rights and does not participate in the company's growth the way common stock does.

The economics start from par value. A preferred share is issued with a stated par, commonly $25 for shares marketed to individuals and $1,000 for institutional issues, and a dividend rate applied to that par. A 6% preferred on a $25 par pays $1.50 a year regardless of how the company's earnings grow, which is why preferred stock behaves like a fixed-income holding: when prevailing interest rates rise, the fixed payment is worth less and the price falls, and when rates fall, the price rises.

Several features vary by issue and change the risk. A cumulative preferred requires any skipped dividends to accumulate and be paid in full before common shareholders receive anything, while a non-cumulative preferred lets a skipped dividend simply be lost. Most preferred stock is callable, meaning the issuer can redeem it at a set price after a set date, which caps the investor's upside because a share is most likely to be called precisely when rates have fallen and the investor would least want to give it up. Some preferred is convertible into a fixed number of common shares, which adds upside at the cost of a lower dividend. Preferred dividends are usually discretionary rather than a legal debt, so a company can suspend them without triggering default the way skipping a bond's interest would, which is the central risk that distinguishes preferred stock from the bonds it otherwise resembles.

Taxes depend on the issuer. Dividends from a domestic corporation's traditional preferred stock can qualify for the lower qualified-dividend tax rates if the holding-period rules are met, but many securities sold as "preferred" pay distributions that are not qualified dividends, such as those from real estate investment trusts, or that are actually interest, such as the trust preferred securities issued by some banks. How a given preferred is taxed follows from what it legally is, a point covered under dividend, so the label on the share is not enough to tell an investor how the income will be treated.

A preferred share pays a set dividend and sits in a fixed place in the company's payment order.

The dividend is the rate times par, so a 6.5% preferred on a $25 par pays $1.625 a year, typically in quarterly installments. That payment does not rise if the company prospers, and the company must pay it before any common dividend, but for most preferreds the board can suspend it in hard times without defaulting.

A hypothetical example shows the interest-rate effect. Suppose an investor buys a $25-par preferred paying a 6% dividend, or $1.50 a year, at its $25 issue price, for a 6% yield. If market yields for similar securities later rise to 8%, new buyers will only pay a price at which $1.50 represents an 8% yield, roughly $18.75 ($1.50 divided by 0.08). The dividend has not changed, but the share has lost about 25% of its value because the fixed payment must now compete with higher-yielding alternatives. The same math runs in reverse if rates fall, though a callable preferred's gain is capped near its call price.

Pros

• Pays a higher fixed dividend than the same company's common stock and ranks ahead of common shares for both dividends and liquidation.
• Traditional preferred from a domestic corporation may pay qualified dividends taxed at the lower long-term rates.
• More predictable income than common stock for an investor who wants stability over growth.

Cons

• Little or no participation in the company's growth, and usually no vote.
• The fixed payment makes the price fall when interest rates rise, like a bond, without a bond's contractual promise to pay.
• Most issues are callable, so the issuer can redeem the shares just when the investor would most want to keep them.
• The dividend is often discretionary, so it can be suspended without a default, and it ranks behind every bondholder and creditor.