Preferred Stock

A preferred stock is a fixed-income security that behaves like a hybrid of a stock and bond. While preferred stock have characteristics of both stocks and bonds, they share more similarities with the latter. People who invest in preferred stock may want the best of both worlds meaning they want enough risk to potentially get above average returns, but also want the security of dividend payments.

The Basics of Preferred Stock

Preferred stock share many similarities with bonds but differ in several ways too. Like bonds, preferred stock are a fixed-income asset meaning you can receive regular income or fixed dividends from your initial investment. There are various types of preferred stock and they all have upsides and downsides for investors.

Non-cumulative Preferred Stock
A downside of preferred stock is that if they’re what’s called non-cumulative preferred stock-a type of preferred stock that allows companies to miss dividend payments without legal implications. The risk in this type of preferred stock is that investors could lose out on money.

Callable Preferred Stock
Organizations issuing preferred stock can delay dividend payments and distribute them to investors at a later date. They may decide to do this to buy more time if they’re unable to make the payments. Preferred stock can also be redeemed or called, meaning they can be repurchased by the issuer at a predetermined price.

Keeping this in mind, investors should go in with their eyes open when putting their money into this type of preferred stock.

Convertible Preferred Stock
In some cases, an investor can choose to convert a certain number of preferred stock into common stock based on a fixed price. This process is known as voluntary convertible preferred stock. Cases where this type of preferred stock can be beneficial is if market share prices rise above the conversion price. You could end up gaining more profit than you would if you left your investment as a preferred stock. However, a tradeoff is that you forfeit your rights as a preferred stockholder.

An issuer can also decide when to convert preferred stock into common stock and if they do, it’s typically when they need to raise money. This is called mandatory convertible preferred stock and investors are subject to a specified conversion date.

The Risks And Rewards of Preferred Stock

Some of the main benefits of preferred stock is that their investors take priority over common stockholders when it comes to dividend payments. This means any cash a company has goes towards dividend payments for preferred stockholders. Likewise, missed dividend payments must be made to preferred stockholders before common stockholders. That said, preferred stock investors aren’t first in line when it comes to assets and earnings-they fall in the middle. The order of priority is usually bond investors, then preferred stockholders, and finally common stockholders.

Also, preferred stockholders are usually paid first in the event that a company’s assets are liquidated. This makes them less risky than common stock but higher risk than bonds.

In terms of risks, the terms of preferred stock varies between companies so reading the fine print is critical. As mentioned above, companies can default on dividend payments, which could leave investors in the negative.

Pros and Cons

Here is a recap of the pros and cons of preferred stock.

Pros

• Par value-original and fixed value of the share that determines dividend payment
• Fixed dividend payments
• Potentially higher returns than bonds and common stock dividends

Cons

• No voting rights
• Companies can legally skip or default on payments
• Affected by changing interest rates
• Less liquid than common shares as many companies don’t sell them

Buying Preferred Stock

Investors can buy preferred stock on the stock exchange as with common stock. Common places to find preferred stock include with a bank, insurance company, or real estate investment trust (REIT).

Since there is risk with preferred stock, check a company’s credit rating before buying preferred stock. Investors can do so using Moody’s or S&P. These platforms can help you assess how likely the company is to repay their debt.

Preferred stock can be an attractive investment for investors who are open to risk. For those who aren’t, bonds may be a lower-risk investment.