Now that you understand common stock, you can see how preferred stock offers a different kind of ownership, one that trades some upside potential for more predictable income.
What Is Preferred Stock?
- Preferred stock is a hybrid security with characteristics of both equity and debt
- Pays a fixed dividend (stated as a percentage of par value or a dollar amount). "Fixed" describes the rate, not a guarantee of payment: the board of directors must still declare each dividend, and skipping a preferred dividend is not a default the way a missed bond interest payment is
- Dividends are paid before common stock dividends
- Has priority over common stock in liquidation, but is subordinate to all debt
- Generally carries no voting rights
- Price is sensitive to interest rate changes (similar to bonds)
Think of it this way: Preferred stock sits halfway between a bond and a stock. Like a bond, it pays a fixed amount of income and its price rises and falls with interest rates. Like a stock, it represents ownership in the company. The tradeoff is straightforward: preferred stockholders get more predictable income and higher priority than common stockholders, but they give up voting rights and unlimited upside potential.
Exam Tip: Gotchas
- Preferred stock generally has NO voting rights. Common stock does. This is a frequent exam distinction.
- Preferred stock price moves inversely with interest rates, just like bonds (rates up, price down). The fixed dividend makes it behave more like a bond than a stock.
- A fixed dividend is not a guaranteed dividend. The board must declare it each period. Preferred dividends are more reliable than common (which has no stated rate), but less protected than bond interest (a legal obligation the issuer must pay or risk default). Skipping a preferred dividend is not a default.
Types of Preferred Stock
| Type | Key Feature | Dividend | Interest Rate Risk |
|---|---|---|---|
| Straight (standard) | Fixed dividend, no extras | Fixed | High |
| Cumulative | Missed dividends accumulate as "arrearages" | Fixed, accumulates | High |
| Non-cumulative | Missed dividends are lost forever | Fixed, no catch-up | High |
| Participating | Shares in extra profits beyond stated dividend | Fixed + variable bonus | Moderate |
| Convertible | Can convert to common stock | Fixed (lower yield) | Moderate |
| Callable | Issuer can redeem at a set price after a date | Fixed | High |
Cumulative Preferred
- If the company skips a dividend payment, the unpaid amount accumulates as arrearages
- ALL arrearages must be paid before any common dividends can be declared
- This is the most protective type of preferred stock for investors
Exam Tip: Gotchas
- Cumulative preferred is the most tested preferred stock concept on the SIE. ALL accumulated unpaid dividends (arrearages) must be paid before ANY common dividends can be declared. If a company has $6 in arrearages and a $2 current dividend on cumulative preferred, it must pay $8 per share to preferred holders before paying a single penny to common shareholders.
Non-Cumulative Preferred
- If the company skips a dividend, it is gone forever. There is no catch-up.
- Less desirable to investors than cumulative preferred
Participating Preferred
- Receives its stated dividend PLUS a share of additional profits
- Offers upside beyond the fixed rate in strong earnings years
- Carries a lower stated dividend rate than straight preferred because of this extra benefit
Convertible Preferred
- Can be exchanged for a specified number of common shares
- Carries a lower dividend yield than non-convertible preferred because investors accept less income in exchange for the conversion privilege
- Provides some inflation protection through the ability to convert to common stock
Exam Tip: Gotchas
- Convertible and participating preferred carry LOWER stated dividend rates because of their extra features. Investors accept less income in exchange for the conversion privilege or profit-sharing.
Callable Preferred
- The issuer has the right to redeem (buy back) shares at a predetermined price after a specified date
- Companies call preferred stock when interest rates fall so they can reissue at a lower dividend rate
- Call risk: investors face the possibility of losing a favorable dividend stream
Exam Tip: Gotchas
- Callable preferred benefits the ISSUER, not the investor. The issuer calls when rates fall so they can reissue at a lower dividend rate. The investor loses a favorable income stream.