As someone who has spent years analyzing investment opportunities, I find that preferred stock often gets overlooked by beginners. Yet, it plays a crucial role in corporate finance and can be a valuable addition to an investor’s portfolio. In this guide, I’ll break down everything you need to know about preferred stock—how it works, why companies issue it, and how it compares to common stock and bonds.
Table of Contents
What Is Preferred Stock?
Preferred stock is a hybrid security that blends features of both equity and debt. Unlike common stock, which represents ownership in a company, preferred stock functions more like a bond with fixed dividend payments. However, it still carries equity characteristics, such as potential capital appreciation.
Key Features of Preferred Stock
- Fixed Dividends – Preferred shareholders receive dividends at a predetermined rate, usually expressed as a percentage of par value. For example, a 5\% preferred stock with a \$100 par value pays \$5 annually.
- Priority Over Common Stock – In case of bankruptcy or liquidation, preferred shareholders get paid before common shareholders (but after bondholders).
- No Voting Rights – Unlike common stock, preferred shares typically don’t grant voting power.
- Convertible Options – Some preferred stock can be converted into common stock at a preset ratio.
- Callable Feature – Companies can often repurchase preferred stock at a specified price after a certain date.
Types of Preferred Stock
Not all preferred stock is the same. Below are the most common types:
| Type | Description | Example |
|---|---|---|
| Cumulative | Unpaid dividends accumulate and must be paid before common dividends resume. | If a company skips a \$2 dividend, it owes \$4 next year. |
| Non-Cumulative | Missed dividends are not carried forward. | No obligation to pay skipped dividends. |
| Participating | Shareholders receive extra dividends if company profits exceed a threshold. | Beyond fixed 5\%, they may get an additional 2\%. |
| Convertible | Can be exchanged for common stock at a predetermined ratio. | 1 preferred share = 2 common shares. |
| Adjustable-Rate | Dividend rate fluctuates based on a benchmark (e.g., LIBOR + 2\%). | Rate resets quarterly. |
Why Companies Issue Preferred Stock
From a corporate finance perspective, preferred stock offers flexibility. Unlike debt, missed dividends don’t trigger bankruptcy (unless cumulative). It also doesn’t dilute voting control since preferred shareholders usually lack voting rights.
For example, if Company XYZ needs capital but doesn’t want to increase debt levels, issuing preferred stock at 6\% dividend yield might attract investors without the strict covenants of bonds.
Preferred Stock vs. Common Stock vs. Bonds
To understand where preferred stock fits, let’s compare it to common stock and bonds:
| Feature | Preferred Stock | Common Stock | Bonds |
|---|---|---|---|
| Dividends/Interest | Fixed dividends | Variable dividends | Fixed interest payments |
| Priority in Liquidation | Second to bonds | Last | First |
| Voting Rights | Generally none | Yes | No |
| Potential for Capital Gains | Limited | High | None (unless convertible) |
| Risk Level | Moderate | High | Low |
Calculating the Value of Preferred Stock
As an investor, I need to assess whether a preferred stock is fairly priced. The value can be estimated using the dividend discount model (DDM):
P = \frac{D}{r}Where:
- P = Price of preferred stock
- D = Annual dividend
- r = Required rate of return
Example: If a preferred stock pays \$5 annually and my required return is 6\%, the fair value is:
P = \frac{5}{0.06} = \$83.33If the market price is below this, it may be undervalued.
Tax Implications
Preferred dividends are taxed differently than bond interest. In the U.S., qualified dividends (including most preferred stock dividends) are taxed at capital gains rates (0\%, 15\%, or 20\%), whereas bond interest is taxed as ordinary income.
Risks of Preferred Stock
While preferred stock is generally safer than common stock, it’s not risk-free:
- Interest Rate Risk – Prices fall when interest rates rise.
- Credit Risk – If the issuer faces financial trouble, dividends may be suspended.
- Call Risk – The issuer may redeem shares early if interest rates decline.
Real-World Example: Bank of America Preferred Shares
Bank of America (BAC) has issued several preferred stock series. One such series, BAC.PRL, offers a 6.25\% fixed-to-floating rate dividend. If par value is \$25, the annual dividend is:
25 \times 0.0625 = \$1.5625If market rates rise, the price may drop below par, increasing yield for new buyers.
Final Thoughts
Preferred stock is a unique asset class that balances risk and reward. It’s ideal for income-focused investors who want higher yields than bonds but with less volatility than common stocks. However, understanding its nuances—such as cumulative features, callability, and tax treatment—is crucial before investing.
