When it comes to preferred stocks, most investors would agree that the details can be confusing.
But understanding the key features of preferred stocks allows you to evaluate them properly and construct a balanced portfolio.
In this post, we'll break down the critical differences between preferred and common stocks, walk through the main preferred stock variants, and compare these instruments to other assets to determine where they fit in an investment plan.
Introduction to Preferred Stocks
Preferred stocks are a type of equity security that have features of both stocks and bonds. They offer fixed dividend payments like bonds, but also have an ownership stake in the company like common stocks.
Understanding Preferred Stock Dividends
- Preferred stocks pay dividends at a fixed, preset rate known as the "dividend rate." This provides more stable income than common stocks.
- Dividends can be cumulative or noncumulative. Cumulative dividends must be fully paid before common stock dividends.
- The dividend rate is typically displayed as a percentage of the stock's par value, which is usually $25 per share. For example, a 6% dividend rate equals a $1.50 annual dividend on a $25 par value preferred share.
Key Differences from Common Stocks
- Preferred shareholders have priority over common shareholders for dividend payments and assets in case of liquidation, but limited voting rights.
- Preferred stocks generally have less potential for capital appreciation compared to common stocks.
- Preferred stocks have seniority over bonds and equity in case of bankruptcy.
Advantages of Preferred Stocks
- Higher fixed dividends than bonds and priority over common dividends provides steady income stream.
- Preferred dividends may qualify for lower tax rates compared to bonds.
- Senior to common stock and bonds reduces default risk exposure.
- Some preferreds have convertibility features or high yields over 10%.
Disadvantages of Preferred Stocks
- Limited upside as most preferreds have fixed dividends without participation rights.
- Companies can defer preferred dividends during financial difficulty.
- Not as senior as corporate bonds and lack bond protections.
- Low trading volumes can limit liquidity compared to common stock.
What are the features of preferred stock in finance?
Preferred stock has several key features that distinguish it from common stock in corporate finance:
Preference in Dividends
Preferred shareholders are entitled to receive dividend payments before any dividends are paid to common shareholders. The dividend rate is usually specified as a percentage of the par value of the preferred shares when issued.
Preference in Assets and Liquidation
In the event a company goes bankrupt or liquidates its assets, preferred shareholders have a right to receive payment from any remaining assets before common shareholders. This gives preferred stockholders a higher claim on assets.
Convertibility
Some preferred stock is convertible, meaning it can be exchanged for a specified number of common shares at the shareholder's discretion. This allows preferred shareholders to benefit from stock price appreciation.
Callability
Issuers may include a call provision allowing them to repurchase or redeem preferred shares at a specified price on certain dates. This lets companies refinance higher cost preferred stock if market rates decline.
Non-Voting
Preferred shares usually do not carry voting rights like common shareholders. However, preferred shareholders may gain voting rights if dividends are in arrears beyond a specified time period.
In summary, preferred stock offers investors priority claims to dividends and assets with less exposure to downside business risk. The trade-off is preferred shareholders lack voting control and upside profit potential like common shareholders. Understanding these key differences allows informed investment decision making.
What are the features of preference shares in finance?
Preference shares have several key features that make them unique financial instruments for investors:
Preferential Dividend Payments
Preference shareholders have priority over common stockholders when it comes to dividend payments. Companies must pay dividends on preferred shares before distributing dividends to common shareholders. This gives preference shares more reliable income potential.
Limited Voting Rights
Preference shareholders usually do not have voting rights attached to their shares. This means they forgo voting on company matters in exchange for priority dividend payments.
Priority Claim on Assets
In the event a company goes bankrupt or gets liquidated, preferred shareholders have a priority claim on company assets over common shareholders. This helps reduce the investment risk associated with preference shares.
Fixed Dividend Amounts
Most preference shares pay a fixed dividend amount, expressed as a percentage of the share price. This allows investors to lock in consistent dividend income as long as they hold the shares. The dividend does not fluctuate based on company profits like common stock dividends.
So in summary, key features of preference shares include preferential dividends, limited voting rights, priority assets claim, and fixed dividend payouts. These features allow preference shares to offer a unique risk-return profile for investors relative to other financial instruments. Understanding these features can help investors evaluate if preference shares fit their investment objectives.
What are preferred stock participating features?
Participating preferred stock is a special type of preferred stock that gives holders additional dividend payments when dividends are paid to common shareholders. This means participating preferred shareholders receive:
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Their standard preferred dividend payment, which is usually a fixed percentage rate based on the stock's par value. For example, a 6% dividend on a $100 par value preferred stock would pay a $6 annual dividend.
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An additional "participating" dividend equal to the dividend paid on an equivalent number of common shares, when common stock dividends are declared.
For example, if the participating preferred stock was convertible into 100 common shares, and the company paid a $1 per share dividend to common shareholders, participating preferred holders would get an extra $100 dividend payment.
This gives participating preferred shareholders higher dividend income compared to regular preferred stocks. The trade-off is the stock usually has a higher price and lower yield to compensate for the participating feature.
Key advantages of participating preferred stocks include:
- Higher dividend potential - Holders get extra dividends tied to common share payouts
- Convertibility - Most are convertible into common shares
- Priority over common dividends - Preferred dividends must be paid first before common
- Less risk than common shares - Preferred has priority in bankruptcy/liquidation
In summary, participating preferred gives investors priority, relative safety of preferred shares, plus the ability to participate in higher common share dividends. This makes it appealing for investors seeking income and moderate growth.
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What are the major features of common and preferred stock?
Preferred stock and common stock have some key differences that investors should understand. Here is an overview of some of the major features:
Dividends
- Preferred shareholders have priority over dividends. They must be paid before common shareholders receive dividends.
- Preferred dividends are typically fixed at a set percentage or dollar amount. Common dividends vary based on profits.
Voting Rights
- Common stockholders usually have voting rights allowing them to vote on company matters.
- Preferred shareholders generally do not have voting rights.
Claims on Assets and Earnings
- In the event of liquidation, preferred shareholders have a higher claim on assets and earnings than common shareholders.
- Preferred shares must be repaid before common stockholders have any claim.
Convertibility
- Some preferred shares are convertible into a fixed number of common shares after a predetermined date. This gives holders the option to convert to common stock.
In summary, preferred shares offer more security and fixed returns, while common stock offers higher potential profits and voting rights. Investors should weigh these key differences when deciding the right stock mix for their portfolio.
Features and Types of Preferred Stocks
Preferred stocks have unique features that set them apart from common stocks. Understanding these key differences can help investors evaluate which type of stock aligns with their financial goals.
Cumulative vs Noncumulative Dividends
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Cumulative preferred stocks ensure investors receive all unpaid dividends before common shareholders receive dividends. Unpaid dividends accumulate over time.
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With noncumulative preferreds, unpaid dividends do not accrue. Investors forfeit dividends if the company chooses not to pay.
Cumulative preferreds provide more dividend security for investors. Companies lean towards noncumulative shares since they face less obligation to pay dividends during challenging times.
Callable vs Non-callable Preferred Shares
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Callable preferred shares allow the issuing company to repurchase or redeem shares at a preset price after a defined period, essentially recalling the stock.
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Non-callable preferred stock cannot be repurchased by the company before the maturity date.
Issuing callable preferred shares benefits companies by retaining flexibility over share structure. However, callable status can lower preferred share prices and average yields.
Participating vs Non-participating Preferreds
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Participating preferred stocks pay investors standard dividends plus an additional dividend that tracks a company’s common shares. Investors participate in earnings growth beyond fixed dividend payments.
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Non-participating preferreds only pay defined dividends and do not offer earnings-based dividends.
Participating preferreds are less common but allow investors to gain higher yields during growth periods through participation dividends. Companies may favor participating preferreds to attract investment capital.
Convertible vs Non-convertible Preferred Shares
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Convertible preferred shares can be exchanged for a set number of common shares, usually at the investors' discretion. They function similar to convertible bonds.
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Non-convertible shares cannot be converted into common stock.
The conversion feature offers investors flexibility and the potential for capital appreciation. Companies can use convertible preferreds to lower dividend costs during lean times.
Evaluating and Investing in Preferred Stocks
Preferred stocks can provide attractive income streams through regular dividend payments. However, when evaluating potential investments, it is important to carefully analyze the financial health of the issuing company.
Assessing Dividend Payments and Credit Quality
When examining preferred share dividend payments, investors should review the company's retained earnings and overall debt levels. Companies with strong earnings and reasonable debt loads are generally better positioned to continue making preferred dividends. The risk of suspended or reduced payments rises if earnings decline or debt expenses overwhelm cash flows.
Additional factors to weigh include the size of the company, its credit rating, industry health, and management reputation. Larger, investment-grade issuers with steady revenue streams often present lower risk.
Understanding Call Risk
Many preferred stocks have call provisions allowing the issuer to repurchase shares at par value after a specified date. This can limit income duration if shares are called when market rates fall below the fixed dividend rate.
Investors should assess the potential for early calls based on yield spreads over benchmark rates like the 10-year Treasury. Wider spreads above market rates reduce call likelihood in the near-term.
Accounting for Potential Share Dilution
For convertible preferred stocks, investors must also evaluate the possible dilution effects from conversion into common shares. More conversions can increase share count and reduce ownership stakes for existing shareholders.
Dilution risk rises when the common share price trends higher above the conversion price threshold. Reviewing the company's equity offering history can also provide context on share count impacts.
Constructing a Diversified Preferred Stock Portfolio
Since preferred stocks carry more risk than bonds, adequate diversification is key. Investors can mitigate risks by holding a basket of preferreds across various issuers, industries, credit qualities and maturity dates.
For simpler diversification, preferred stock ETFs and mutual funds provide a single vehicle for exposure across dozens of underlying issues. Actively managed funds may also shift holdings to take advantage of yield opportunities or reduce sector concentration risks.
Comparing Preferred Stocks to Other Investments
Preferred Stocks vs Corporate Bonds
Preferred stocks share some key features with corporate bonds, such as providing fixed dividend payments and having priority over common stockholders. However, preferred stocks differ in that they do not have a maturity date like most bonds. Preferred stocks also offer tax-advantaged dividend income compared to the interest payments from corporate bonds.
On the other hand, bonds have greater seniority in the capital structure. In case of liquidation, bondholders get paid before preferred shareholders. So corporate bonds generally carry lower risk than preferred stocks. Investors should weigh these tradeoffs based on their risk tolerance and income needs.
Preferred Stocks vs Common Stocks
The main appeal of preferred stocks is the consistent dividend payments, whereas common stocks offer higher growth potential but less predictable dividends. Preferred shareholders also lack voting rights held by common shareholders.
For investors focused on income stability over growth, preferred stocks may be more suitable. But investors comfortable with some volatility can pursue higher total returns from common stocks over the long run. Diversifying across both preferred and common shares may help balance these objectives.
Preferred Stocks vs REITs and Mezzanine Debt
Real estate investment trusts (REITs) provide exposure to income-generating property assets. Like preferred stocks, REITs offer higher dividend yields than bonds or common stocks. But REIT values can fluctuate with the real estate market.
Mezzanine debt resides between a company’s senior and equity debt. It carries more risk than senior bonds but offers higher potential returns. So in terms of risk-return profiles, mezzanine debt tends to align more closely with preferred shares than REITs do.
Ultimately, preferred stocks help diversify a portfolio beyond just stocks and bonds. Allocating across preferreds, REITs and other alternatives can further help manage portfolio risk and income.
Conclusion and Key Takeaways
Preferred stocks occupy an interesting middle ground between bonds and common stocks. They provide regular income like bonds, but also offer capital appreciation potential more similar to common stocks. However, they come with more complexity around call provisions, potential dilution effects, and credit risk analysis.
When invested in properly and held as part of a diversified portfolio, preferred stocks can provide attractive tax-advantaged income along with moderate growth. However, they require research and active monitoring to avoid potential downsides.
Summary of Preferred Stock Features
- Preferred stocks pay fixed dividends that must be paid before common stock dividends
- They are less risky than common stocks but more risky than bonds
- Owners have priority over common stocks in bankruptcy, but not debt holders
- Convertible and participating preferreds add capital gains potential
- Non-cumulative preferreds can skip dividends in tough times
Essential Tips for Investing in Preferred Stocks
- Research credit quality to avoid defaults risk
- Understand call provisions that allow the issuer to redeem shares
- Assess potential dilution from conversions or new share issues
- Construct a diversified portfolio across sectors and risk profiles
- Reinvest dividends to compound returns over the long run
Balancing preferred stocks with other assets can enhance a portfolio's risk-adjusted returns. But proper due diligence is vital to avoid potential pitfalls. Evaluating both financial metrics and legal terms is key to determining an appropriate entry point.
