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What Is Preferred Stock? Definition, Pros & Cons

Preferred stock is a hybrid security that has features of both common stock and corporate bonds.
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Preferred stock, like common stock, represents partial ownership of a company, but it usually does not come with voting rights.

What Is Preferred Stock and How Does It Differ From Common Stock?

Preferred stock is a unique type of equity that grants shareholders priority over common stockholders in terms of dividend distribution and—in the event a company goes bankrupt—asset distribution. 

Additionally, most preferred stock comes with a fixed, regular dividend, unlike common stock, for which dividends may or may not be paid at any given interval at the company’s discretion. Companies can, however, lower or discontinue dividend payments on preferred shares if earnings slump, but only after discontinuing any dividend payments on common shares.

Unlike common stock, preferred stock usually does not bestow shareholders with voting rights (and when it does, these rights are usually limited). Additionally, because of the fixed income payments preferred stock typically comes with, it is usually less volatile in price than common stock, as less of its value is derived from company performance.

Preferred stock shares don’t mature in the same way corporate bonds do, but usually, they do have a date after which they are callable. This means they can be returned to the company by investors for their par value. Like common shares, preference shares do have market value, but it doesn’t usually stray particularly far from par value, which is the original share value based on which dividend yield is calculated.

Overall, preferred stock can be thought of as a cross between common stock and a corporate bond in that it has characteristics of both an equity instrument (like company ownership) and a debt instrument (like fixed income payments).

What Are the Advantages of Owning Preferred Stock?

Because its value comes mostly from its fixed dividend payments, preferred stock is usually more stable in price than common stock, and this stability can be advantageous during times of economic uncertainty. Additionally, the dividends paid to preferred shareholders are typically higher than those paid (if any) to common stockholders.

In some cases, preferred shares are convertible, meaning they can be exchanged for a predetermined number of shares of common stock. This can allow investors to switch gears, so to speak, from fixed income payments to potential capital gains.

In the event a company can’t afford to pay dividends to all shareholders, preferred shareholders take priority over common stockholders. Similarly, if a company goes bankrupt and must liquidate its assets in order to pay creditors, preferred shareholders are paid before common stockholders.

What Are the Disadvantages of Owning Preferred Stock?

Preferred shares usually don’t come with voting rights (and when they do, they are usually limited), so preferred stockholders don’t typically have much say in a company’s elections and major business decisions. 

Additionally, because preferred shares aren’t very volatile, they are less likely to go up significantly in value in response to company success. Of course, if an investor is holding convertible preferred shares, they could exchange them for shares of common stock to make a profit if share price goes up significantly, but not all preferred shares are convertible.

Why Do Companies Issue Preferred Stock?

Companies issue preferred stock for the same general reason they take out loans or issue corporate bonds or common stock—to raise capital. That being said, preference shares do have some advantages over these other cash-generating activities.

First, preference shares, despite their similarity to corporate bonds, count as equity, so issuing them lowers a company’s debt-to-equity ratio, the most popular leverage ratio investors and analysts use to evaluate company debt-related health. Issuing corporate bonds, on the other hand, raises a company’s D/E ratio, which doesn’t send as good of a signal to the public.

Additionally, preference shares don’t come with voting rights, so issuing them doesn’t take any decision-making power away from management.

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TheStreet Dictionary Terms

Pros and Cons of Preferred Stock 

ProsCons

Regular dividends

Few or no voting rights

Low capital loss risk

Low capital gain potential

Right to dividends before common stockholders

Right to dividends only if funds remain after interest paid to bondholders

Right to assets before common stockholders

Right to assets only after bondholders have been paid

What Are the Differences Between Preferred Stock and Corporate Bonds?

Corporate bonds and preferred stock share many characteristics but are not totally alike. Both pay holders on a regular basis—bonds via interest payments and preferred shares via dividend payments—and both are issued by companies to raise capital for operations.

Corporate bonds and preference shares do, however, differ in several important ways. First, bonds mature, at which point the principal must be repaid to the holder. Preference shares, on the other hand, do not mature, although they may be resold on the open market at any time, or if callable, be returned to the company for their par value after a certain date.

Additionally, bondholders have higher priority than preference shareholders when it comes to both income payments and asset distribution. If a company is struggling with earnings, it will pay its bondholders interest before paying any dividends to preference shareholders. Should a company become insolvent and go bankrupt, the proceeds of its asset liquidation will also be distributed to bondholders before preference shareholders.

Furthermore, bonds are loans, so they do not grant their holders any ownership of the underlying company. Preference shares, on the other hand, are equity instruments and do represent company ownership, although usually without voting rights.

What Types of Investors Buy Preferred Stock?

Preferred stock is most often purchased in bulk by institutional investors for its tax advantages, but when it comes to individual (AKA “retail”) investors, those who buy a lot of preferred stock tend to be relatively risk-averse investors seeking regular passive income payments (e.g., dividend investors).

During market slumps, bear markets, and recessions, preferred shares often become popular with a wider variety of investors due to their relative stability compared to common stock and their fixed dividend payments.

Are Preferred Shares Debt or Equity Instruments?

Preferred shares are technically equity instruments, as they represent ownership in a company, but they share many characteristics of debt instruments like corporate bonds. For example, their market value is less volatile than common equity, they provide fixed income payments, and many are callable, meaning they can be returned to the underlying company after a certain date for par value.

Because they share so many features with bonds, many investors consider preferred stock to be a sort of hybrid security.

  • iShares Preferred and Income Securities ETF (NASDAQ: PFF)
  • Invesco Preferred ETF (NYSEARCA: PGX)
  • Innovator S&P Investment Grade Preferred ETF (BATS: EPRF)
  • Principal Spectrum Preferred Securities Active ETF (NYSEARCA: PREF)

Frequently Asked Questions (FAQ)

Below are answers to some of the most common questions investors have about preferred stock.

Do All Companies Offer Preferred Stock?

Not all companies offer preferred shares. Most only offer common stock. That being said, a company can issue preferred stock at any time.

What Is Convertable Preferred Stock?

Convertible preferred shares are like other preferred shares, but they come with the benefit that they can be exchanged for a preset amount of common stock, which can be advantageous to an investor if the underlying company’s common stock goes up significantly in value.

Where can Preferred Stock Be Found on the Balance Sheet?

Preferred stock is listed in the shareholders’ equity section of a company’s balance sheet.

Is Preferred Stock a Hybrid Security?

Yes, because preferred stock combines characteristics of both debt and equity instruments, it is considered by most investors to be a hybrid security.

Is Preferred Stock Included in Market Capitalization? Shareholders’ Equity?

Yes, preferred shares are shares of stock, so they are included in both market cap and shareholders’ equity. 

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