What is Preferred Stock?
Preferred stock refers to a class of shares which has a higher ranking than common stock. Preferred stock does not carry any voting rights as do the common shares, however, they command priority over the common stock in the event of bankrupcy or liquidation. This means that as assets are sold off, preferred shares will be paid out after debt holders but before common stock holders.
Preferred stock is largely popular with corporate entities due to their tax-exempt status in the tax code. This tax benefit does not exist for individuals and therefore makes this security a bit less attractive.
Preferred Stock & Dividends
Preferred stock also has a major advantage when you consider dividends. Dividends are paid out to preferred owners before it any common shareholders receive any. Furthermore, if a corporation is not able to fullfill its dividend obligation to its preferred holders, many companies will accumulate the benefit until they can pay the accumulated dividend out. Dividends are usually negotiated or given as a percentage of the par value; however, in some cases, dividends are paid out with a variable rate which is tied to an interest rate such as LIBOR, or Federal Funds.
Similarity to Debt Securities
Preferred shares are often referred to as hybrid securities due to the fact that they share many of the same characteristics as debt securities do. The dividends that are paid out act as coupon payments in a sense; therefore, shifts in interest rates will force the preferred security to adjust up or down to make the dividend yield more in line with the market. Due to the risk associated with preferred stock, in relation to debt securities, yields are higher than that of debt securities.
SImilar to convertible bonds, preferred stocks have an embedded option to allow shareholders to convert preferred into common stock. Investors will take part in this if they expect the common shares to appreciate in value far greater than that of the dividend yield associated with the preferred stock.
Types of Preferred Stock
Cumulative Preferred - The majority of preferred stock is considered to be cumulative preferred. As discussed above, cumulative preferred stock has a priority when it comes to dividend payouts and accumulates missed dividend payments for future payout.
Participating Preferred - Participating preferred stock allow for the the preferred share holders to take part in a companies success in the form of higher dividend payments. The minimum dividends payout is guaranteed as per the prospectus; however, in the event that the company exceeds its financial goals, an extra dividend may be paid out.
Preference Preferred - When a company makes multiple issuances of the same preferred stock; priority comes into play, even within preferred shares themselves. The first issuance will receive highest priority while the second will receive second priority and so on.
Callable Preferred - Similar to callable bonds, this feature exists in many preferred shares to provide the issuer with the ability to redeem their preferred stock in the future at some point. Preferred yields include a premium to compensate the investor for the added risk that the security may be called away in the future at some point.
Convertible Preferred - This feature allows preferred shareholders to take part in the common stock price appreciation by exchanging their preferred shares for common.