The Basics of Investing in Preferred Stock
Preferred stock is a hybrid between common stock and bonds. Each share of preferred stock is normally paid a dividend, and these dividend payments receive priority over common stock dividends. If the company needs to liquidate assets in a bankruptcy proceeding, preferred stockholders will receive their payments before the common stockholders (but not before the creditors, secured creditors, general creditors, and bondholders).
The trade-off for the often substantially higher dividend yield received by preferred stockholders is the relative inability to actualize capital gains. Unless there are special provisions, preferred stock prices are also like bonds in their sensitivity to interest rate changes. This means that any capital gains enjoyed by the owner will likely come from buying preferred stock before an interest rate decline. Similarly, an increase in the creditworthiness of a firm could also increase the value of that firm's preferred stock.
Cumulative vs. Non-Cumulative Preferred Stock
The terms of preferred stocks can vary widely. Even if two preferred stocks were issued by the same company, there can be differences if the shares weren't issued as part of the same preferred stock "series." Arguably, the most important characteristic of a preferred stock is whether or not the dividend is cumulative or non-cumulative.
In a cumulative issue, preferred dividends that are not paid pile up in an account. These unpaid dividends are referred to as "in arrears." Before any dividend can be paid to the common stockholders, all "dividends in arrears" must be distributed to the preferred stockholders in full.
If a preferred stock issue is non-cumulative and the dividend payment is missed, the preferred shareholders are out of luck. They will never receive that money, even if the company produces record-breaking profits months later.
Provisions That Influence Preferred Stock Value
Several additional provisions can affect the value of preferred stock. These considerations include shareholder voting rights, the rate of interest, and whether or not the shares can be converted to common shares.
Preferred Stock Variations
These are some of the most common variations of preferred stock, but a company can determine the details of its preferred stock as it sees fit. Therefore, it's possible to find stocks that include a mix of these characteristics, as well as ones that aren't listed here.
Voting vs. Non-Voting
Owners of preferred stock usually do not have voting rights. There have been cases throughout history in which preferred shares only received voting rights if dividends had not been paid for a stipulated length of time. In such cases, significant—if not controlling—voting power can be effectively transferred to the preferred shareholders.
Holders of preferred stock receive a dividend that differs based on any number of factors stipulated by the company at the issuer's initial public offering. Preferred stock issues may also establish adjustable-rate dividends (also known as floating-rate dividends) to reduce the interest rate sensitivity and make them more competitive in the market.
Holders of this type of security have the right to convert their preferred stock into shares of common stock. It allows the investor to lock in the dividend income and potentially profit by converting their shares after the price of the common stock rises. On the other hand, if the price of the common stock plummets, the investor can hold off on converting their shares. Their investment is unaffected by the price of common stock until they convert their shares. Under the right conditions, an investor can make a lot of money while enjoying higher income and lower risk by investing in convertible preferred stock.
Shares of this type of preferred stock receive a set dividend plus an additional dividend based on other factors. For example, the additional earnings could be calculated as a percentage of either the net income or the dividend paid to the common stockholders.
The Relative Price Stability of Preferred Shares
If a large drug company discovered a cure for the common cold, one could reasonably expect the company's common stock to skyrocket. The growth in market value is in anticipation of earnings growth from sales of the new drug.
At the same time, the company's preferred shares likely wouldn't budge much in price, except to the extent that the preferred dividend is now safer due to the higher earnings. This additional safety can lead to the market value of the preferred shares rising (which causes the yield to fall), but the movement is unlikely to match that of the common stock.
This Phenomenon Works Both Ways
Imagine, a few weeks later, that same drug company announced that they no longer believe the cure is effective. The price of the common stock would likely plummet, but as long as the business is still expected to honor its preferred stock dividend payments, the preferred stock price would remain relatively stable.
Convertible Shares Are the Exception
Convertible shares like Preference Equity Redemption Cumulative Stock (PERCS) can be converted into common shares. Thus, investors holding these shares have the opportunity to seize on capital gains when the price of a common share rises. In the example scenario of the drug company, the price of the PERCS would have experienced a tremendous rise and fall based on the expected profit an investor could have realized by converting their shares into common stock. As long as the holder of the preferred stock did not convert shares or acquire more preferred stock at the inflated price, they would experience no loss of principal.
The Bottom Line
Preferred stock performs differently than common stock, and investors should be aware of those differences before they invest. The strategies that work best with common stock may not work as well with preferred stock, and vice versa. If you prefer to buy-and-hold investments and emphasize dividend earnings, preferred stock could have a place in your portfolio.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.