Preferred Stock Explained: Where It Sits Between Bonds and Common Shares

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You are reading the fine print of a company's securities and notice a class of shares that pays a fixed quarterly dividend, has a stated par value and sits somewhere between the company's bonds and its ordinary stock. That is preferred stock. It is a hybrid security that pays a set dividend and ranks ahead of common shares, but behind bonds, in a company's claim on income and assets, and the combination makes it behave a little like each of its neighbors without being quite like either.

Key Takeaways

• Preferred stock typically pays a fixed dividend and ranks above common stock but below bonds if a company is liquidated.
• Its price tends to respond to interest rates and the issuer's credit quality more than to the company's growth.
• Features such as cumulative dividends, callability, convertibility and floating rates change how a particular issue behaves.
• Preferred dividends can usually be suspended without a default, which is a key difference from bonds.
• Reading the prospectus for each issue matters, because the terms vary widely.

What Preferred Stock Is

Preferred stock is a class of equity that companies issue to raise capital. Holders usually receive a stated dividend, often expressed as a percentage of a par value such as twenty-five dollars per share, paid before any dividend goes to common shareholders. Unlike common stock, preferred shares typically carry no voting rights in ordinary matters, and their upside is generally limited, because the dividend is fixed and the price tends to hover near par unless interest rates or credit quality change.

The name reflects a priority in line, not any special quality. Preferred holders stand ahead of common shareholders when a company pays dividends or liquidates, but they stand behind creditors, including bondholders. In that sense preferred stock is neither pure ownership nor pure lending.

Companies issue preferred stock for several reasons: it can strengthen certain financial ratios compared with debt, it does not create a legal obligation to pay in the way a bond does and it can appeal to a different group of investors. Banks, utilities and real estate companies have historically been frequent issuers.

Where It Sits in the Capital Structure

Picture a company's financing as a ladder. At the top, in claim order, are secured lenders and bondholders, who are owed interest and principal as a matter of contract. Next come preferred shareholders, who are owed their stated dividend before common shareholders receive anything. At the bottom are common shareholders, who share in whatever remains.

In a good outcome, this ordering rarely matters. In a poor one, it matters a great deal. If a company is liquidated, creditors are paid first, preferred holders next and common holders last, and often little or nothing reaches the lowest rung. That is why preferred stock is generally considered less risky than common stock of the same company and riskier than its bonds.

The ladder also explains why preferred shares typically yield more than the same issuer's bonds, since holders accept a lower claim, and less than the dividend yield of a high-risk common stock, though the relationships change with conditions and should not be assumed.

Features That Change the Picture

The details of each issue matter because they differ widely. Common features include:

• Cumulative dividends. If the company skips a dividend, the unpaid amount accumulates and must be paid before common shareholders receive anything. Non-cumulative preferred stock has no such catch-up.
• Callable terms. The issuer may redeem the shares at a set price after a certain date, which caps price gains and may end your income stream when rates have fallen.
• Convertible terms. Some preferred shares can be exchanged for common stock under set conditions.
• Fixed versus floating rates. A fixed-rate issue pays the same dividend, while a floating-rate issue adjusts with a reference rate.
• Perpetual terms. Many preferred shares have no maturity date, so the principal is not returned on a schedule.

Each feature changes risk. A callable issue that trades above its call price may be redeemed, leaving the holder with a loss relative to what was paid. A perpetual fixed-rate issue can lose value when interest rates rise, because new securities offer higher payments.

The Risks to Understand

The first risk is interest-rate sensitivity. Because the dividend is fixed, rising rates make the existing payment less attractive and tend to push prices down, much as with long-term bonds. Falling rates have the opposite effect, but call features can limit the benefit.

The second is credit risk. Preferred dividends depend on the issuer's health, and companies can usually suspend them without triggering a default, which is a major difference from missing a bond payment. A company in trouble often suspends common and preferred dividends alike, and preferred prices can fall steeply.

Third, liquidity can be limited. Some issues trade thinly, so price quotes can be wide and moves can be exaggerated. Finally, taxes differ. Some preferred dividends may qualify for special tax rates while others do not, and the treatment depends on the issue and on your circumstances, so a qualified tax professional is the right person to ask.

None of this makes preferred stock good or bad. It is a tool with its own tradeoffs, and working with an advisor and self-directing are both legitimate approaches to evaluating it.

An Illustrative Reading

This is a hypothetical example, not a result and not a suggestion about any security. Imagine an executive who comes across a preferred issue while reviewing a company's filings.

She opens the prospectus and records the par value, the dividend rate and whether it is cumulative. She checks the call date and the redemption price, and she notes that the issue is perpetual with a fixed rate. She finds where the shares rank in the capital structure, reads the sentences on when dividends can be suspended and looks at the issuer's credit disclosures. She writes a summary: income is fixed, upside is capped, interest rates and credit are the main drivers, and the terms suggest a call risk. She sets the question aside for a scheduled review and does not act that day.

Frequently Asked Questions

What is preferred stock?

It is a class of shares that typically pays a fixed dividend and ranks ahead of common stock but behind bonds in a company's claims. It combines features of both debt and equity.

Is preferred stock safer than common stock?

It generally sits higher in the claim order and has a more predictable dividend, so it is considered less risky than common stock of the same company. It still carries credit and interest-rate risks and can lose value.

Can a company stop paying preferred dividends?

Usually yes, because preferred dividends are not a legal debt the way bond interest is. Cumulative issues require missed dividends to be paid before common holders receive anything, but non-cumulative issues do not.

How does preferred stock differ from a bond?

A bond is a loan with a fixed schedule of interest and principal, and missing a payment is a default. Preferred stock is equity with a stated dividend, usually no maturity date and no default if a dividend is suspended.

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