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What Is Preferred Stock?

While similar to a bond, preferred stock has some quirks that distinguish it from bonds, including a usually higher payout.
May 30, 2018
Investing
what-is-preferred-stock
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Preferred stock is one of the two major categories of stock that a company can use to fund its operations. While it’s called stock, for investors it actually acts more like a bond.

Preferred stocks typically pay out fixed dividends on a regular schedule and respond to changes in interest rates, as bonds do. Like bonds, preferred stocks have a “par value” that they can be redeemed at, typically $25 per share (versus $1,000 with most bonds). And both can be repurchased, or “called,” by the issuer after a certain period, often five years.

That’s about where the similarities end, however. “Preferreds” have some quirks that separate them from bonds, making them attractive to investors. And while preferred stock shares a name with common stock — the sort most investors buy — don’t get them confused: They’re a world apart when it comes to risks and potentially huge rewards.

The quirks of preferred stock

Preferred stocks have special privileges that would never be found on bonds. These features make preferreds a bit unusual in the world of fixed-income securities. They also make preferreds more flexible for the company than bonds, and consequently preferreds typically pay out a higher yield to investors.

  • Preferreds are often perpetual. Unlike bonds, which have a defined lifetime from the start, preferreds may be issued to be perpetual. That is, unless the company calls, or repurchases, them, the preferreds could remain outstanding indefinitely.
  • Preferred dividends can be postponed (and sometimes skipped entirely) without penalty. This feature is unique to preferreds, and companies will make use of it, if they’re unable to make a dividend payment.
  • Preferred dividends may be cumulative. For preferreds with a cumulative feature, the company may postpone the dividend but not skip it entirely. The company must pay the dividend at a later date.
  • Preferred dividends may be noncumulative. For preferreds that aren’t cumulative, the company may skip paying the dividend completely without any legal penalty. However, this will make it difficult for the company to raise money in the future.

The most common issuers of preferreds are banks, insurance companies, utilities and real estate investment trusts, or REITs. REITs are a particularly prolific issuer of preferreds, because their heavy use of debt makes the flexibility of preferreds attractive. However, most companies do not issue preferred stock, and the total market for them is small.

Preferred stock vs. bonds vs. common stock: Differences

A company usually issues preferred stock for many of the same reasons that it issues a bond, and investors like preferred stocks for similar reasons. For a company, preferred stock and bonds are convenient ways to raise money without issuing more costly common stock. Investors like preferreds because they often pay a higher yield than the company’s bonds do.

So if preferreds pay a higher dividend yield, why wouldn’t investors always buy them instead of bonds? The short answer is that preferred stock is riskier than bonds.

Asset classRiskinessPotential reward
BondsLowLow. Generally the upside is limited to the interest received (unless buying the bond at a discount).
Preferred stockA bit higher than bondsA bit higher than bonds. Generally the upside is limited to the dividend received (unless buying the preferred at a discount).
Common stockModerate to highThe sky’s the limit.

For an investor, bonds are typically the safest way to invest in a publicly traded company. Legally, interest payments on bonds must be paid before any dividends on preferred or common stock. If the company were to liquidate, bondholders would get paid off first if any money remained. For this safety, investors are willing to accept a lower interest payment, and that’s all the upside they can usually expect to receive. So bonds are a low-risk, low-reward proposition.

Next in line is preferred stock. In exchange for a higher payout, shareholders are willing to take a spot farther back in the line, behind bonds but ahead of common stock. (Their preferred status over common stock here is the origin of the name “preferred stock.”) Once bondholders receive their payouts, then preferred holders may receive theirs. Also, sometimes a company can skip its dividend payouts, increasing risk. So preferreds get a bit more of a payout for a bit more risk, but their potential reward is usually capped at the dividend payout.

Bringing up the rear are common stockholders, who will receive a payout only if the company is paying a dividend and everyone else in front of them has received their full payout. In the event of a company’s liquidation in bankruptcy, these stockholders get what’s left over after bonds and preferreds have been made whole. But if the company is a success, there’s no upside cap on their profits, as there are for bonds and preferreds. The sky really is the limit.

So preferred stocks can make an attractive investment for those looking for a higher payout than they’d receive on bonds and dividends from common stocks. But they forgo the safety of bonds and the uncapped upside of common stocks.

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