Quick Answer
Preferred stock is a hybrid security: it pays a fixed dividend rate (declared by the board, not guaranteed) and behaves like a bond in price sensitivity, but it is legally equity, not debt. Preferred dividends have priority over common dividends and preferred ranks ahead of common (but behind all debt) in liquidation. It generally carries no voting rights.
Preferred stock occupies a middle ground between the fixed, bond-like income you studied in fixed income units and the unlimited upside of common stock covered in the previous lesson. Convertible preferred blends both worlds by adding an option to become common stock.
What Are the Core Characteristics of Preferred Stock?
- Pays a fixed dividend, stated as a percentage of par value or a dollar amount
- Example: 6% preferred with $100 par pays $6.00 per year
- Has dividend preference over common stock: if the board declares a dividend, preferred is paid before any common dividend. "Fixed" refers to the rate, not a guarantee of payment; the board must still declare each dividend, and skipping a preferred dividend is not a default the way a missed bond interest payment is
- Has priority over common stock in liquidation (but still subordinate to all debt holders)
- Generally does not carry voting rights
- Less price volatility than common stock
- More sensitive to interest rate changes than common stock (behaves like a bond in this respect)
| Feature | Common Stock | Preferred Stock |
|---|---|---|
| Dividends | Variable, not guaranteed | Fixed rate, not guaranteed; priority over common if declared |
| Voting rights | Yes (typically) | Generally no |
| Liquidation priority | Last | After debt, before common |
| Price volatility | Higher | Lower |
| Interest rate sensitivity | Lower | Higher (like bonds) |
| Upside potential | Unlimited | Limited (fixed dividend) |
Exam Tip: Gotchas
Preferred stock's fixed dividend describes the rate, not a promise to pay. A missed preferred dividend is not a default the way a missed bond coupon is, even though both are described as "fixed."
How Does Convertible Preferred Stock Work?
Convertible preferred stock can be exchanged for a specified number of common shares at the holder's option. This feature gives preferred stockholders access to upside potential while maintaining the downside protection of a fixed dividend.
What Are the Key Conversion Terms?
- Conversion ratio: The number of common shares received per preferred share upon conversion
- Conversion price: The effective price paid per common share upon conversion
- Conversion price = Par value of preferred / Conversion ratio
- Conversion value (parity): The current market value of the common shares you would receive
- Conversion value = Conversion ratio x Market price of common stock
At What Price Does Convertible Preferred Trade?
Convertible preferred trades at the higher of:
- Investment value: its value as straight preferred (based on the fixed dividend and prevailing interest rates)
- Conversion value: what the common shares would be worth if converted today
This creates a price floor (the investment value) with upside potential through conversion.
Think of it this way: Convertible preferred gives you a safety net (the fixed dividend rate) plus a ladder to climb higher (conversion into common shares). If the common stock takes off, you convert and ride the gains. If it doesn't, you keep the preferred and its declared dividends.
Worked Example
A convertible preferred share has $100 par, convertible into 4 shares of common stock:
- Conversion ratio = 4
- Conversion price = $100 / 4 = $25 per share
- If common stock trades at $30: Conversion value = 4 x $30 = $120
- If common stock trades at $20: Conversion value = 4 x $20 = $80 (preferred trades at investment value instead, since it's higher)
Exam Tip: Gotchas
Convertible preferred always trades at the higher of investment value or conversion value. If a question asks what the preferred is "worth," calculate both and pick the larger number.
Why Is Preferred Stock Equity, Not Debt?
Preferred stock looks like a bond:
- Pays fixed income (like coupon payments)
- Sensitive to interest rate changes
- Limited upside potential
- Priority claim over common stock
But preferred stock is equity, not debt:
| Feature | Preferred Stock (Equity) | Bonds (Debt) |
|---|---|---|
| Legal classification | Equity | Debt |
| Dividends/interest | Dividends (not guaranteed) | Interest (contractual obligation) |
| Tax treatment for issuer | Not deductible | Tax-deductible |
| Maturity date | None (perpetual) | Yes |
| Missed payments | No default (but arrears for cumulative) | Default / bankruptcy trigger |
How Does the Dividends-Received Deduction Work?
Preferred dividends are not deductible by the issuing corporation, but corporate investors that receive preferred dividends may benefit from the dividends-received deduction (DRD):
- Corporations owning less than 20% of the payer: 50% deduction
- Corporations owning 20% or more but less than 80%: 65% deduction
- Affiliated group members (80%+ ownership): 100% deduction
This makes preferred stock relatively attractive to corporate investors compared to bonds, since bond interest received is fully taxable to the recipient corporation.
Exam Tip: Gotchas
Preferred dividends are NOT deductible by the issuing corporation (unlike bond interest). Corporate investors, however, may benefit from the dividends-received deduction. This tests both sides of the distinction: who pays vs. who receives.
What Should You Check on Exam Day?
- Preferred stock is equity, not debt, even though it behaves like a bond in price sensitivity and a fixed dividend rate.
- Preferred dividends have priority over common dividends but are not guaranteed; skipping one is not a default.
- Liquidation order: debt, then preferred, then common.
- Convertible preferred trades at the higher of its investment value or its conversion value (conversion ratio x market price of common).
- The issuing corporation cannot deduct preferred dividends, but a corporate holder may qualify for the dividends-received deduction depending on its ownership stake in the payer.