Investors looking to buy stock in a company may be able to choose between two main types of stock: preferred stock or common stock.
Most investors own common stock. But preferred stockholders get priority over common stockholders when it comes to distributions of the company’s profits or liquidation of assets. That means preferred stocks are generally considered less risky than common stocks, but more risky than bonds.
How preferred stock works
While preferred stock shares a name with common stock, don’t get them confused: They’re a world apart when it comes to risks and rewards.
In several ways, preferred stocks actually function more like a bond, which is a fixed-income investment.
- Preferred stocks typically pay out fixed dividends, or distributions of company profits, on a regular schedule.
- Preferred stocks may respond to changes in interest rates.
- Like bonds, preferred stocks have a “par value” that they can be redeemed at, typically $25 per share. And both can be repurchased, or “called,” by the issuer after a certain period, often five years.
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That’s about where the similarities end, however. “Preferreds” have some quirks that separate them from bonds, making them attractive to investors.
Keep in mind: Most companies do not issue preferred stock, and the total market for them is small. The most common issuers of preferred stocks are banks, insurance companies, utilities and real estate investment trusts, or REITs.
What to know about preferred stock
Preferred stocks have special privileges that would never be found with bonds. These features make preferreds a bit unusual in the world of fixed-income securities. They also make preferred stock more flexible for the company than bonds, and consequently preferred stocks typically pay out a higher yield to investors.
- Preferred stock is often perpetual. Bonds have a defined term from the start, but preferred stock typically does not. Unless the company calls — meaning repurchases — the preferred shares, they can remain outstanding indefinitely.
- Preferred dividends can be postponed (and sometimes skipped entirely) without penalty. This feature is unique to preferred stock, and companies will make use of it if they’re unable to make a dividend payment.
- Preferred dividends may be cumulative. For preferred stock 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 preferred stocks 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.
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Preferred stock vs. bonds vs. common stock
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 preferred stock because this type of stock often pays a higher yield than the company’s bonds.
So if preferred stocks 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 class||Riskiness||Potential reward|
|Bonds||Low||Low. Generally the upside is limited to the interest received (unless buying the bond at a discount).|
|Preferred stock||A bit higher than bonds||A bit higher than bonds. Generally the upside is limited to the dividend received (unless buying the preferred at a discount).|
|Common stock||Moderate to high||The 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 — which means bonds are a low-risk, low-reward proposition.
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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 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 preferred stocks 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 bond and preferred stockholders 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.
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.