Preferred Stock
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)
- 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.
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.