Preferred stock is a hybrid security that combines features of both common stock and bonds, offering investors fixed dividend payments with priority over common shareholders. While preferred stockholders typically receive higher yields than bondholders, they accept subordinated claims in the capital structure and usually lack voting rights.
Preferred Stock vs Common Stock vs Bonds
| Feature | Preferred Stock | Common Stock | Corporate Bonds |
|---|---|---|---|
| Dividend/Interest Priority | After bonds, before common stock | Last priority | First priority |
| Payment Type | Fixed dividend (can be suspended) | Variable dividend (not guaranteed) | Fixed interest (contractual obligation) |
| Voting Rights | Usually none | Yes, proportional to shares | None |
| Typical Yield Range | 5% - 7% | 1% - 3% | 3% - 5% |
| Tax Treatment | Often qualified dividends (15%-20%) | Qualified dividends (15%-20%) | Ordinary income (up to 37%) |
| Price Volatility | Moderate (bond-like) | High | Low to moderate |
| Liquidation Priority | After bonds, before common | Last in line | First in line |
| Maturity Date | Often perpetual or callable | No maturity | Fixed maturity date |
| Growth Potential | Limited (trades near par value) | Unlimited upside potential | Limited to interest payments |
What Is Preferred Stock?
Preferred stock represents an ownership stake in a company that sits between bonds and common stock in the capital structure. Like bonds, preferred shares typically pay a fixed dividend on a regular schedule. Like common stock, they represent equity ownership in the issuing company.
The term "preferred" refers to two key priorities these securities hold over common stock. First, preferred shareholders receive dividend payments before any dividends are paid to common shareholders. Second, in the event of bankruptcy or liquidation, preferred shareholders have a higher claim on company assets than common stockholders, though they still rank below bondholders.
According to the Securities and Exchange Commission, preferred securities occupy a unique position in corporate finance, providing companies with flexible capital-raising options while offering investors a middle ground between debt and equity investments.
How Preferred Stock Works
When you invest in preferred stock, you purchase shares with a stated par value and a fixed dividend rate. Most preferred shares have a par value of $25 per share and pay quarterly dividends. The dividend is typically expressed as either a percentage of par value or as a dollar amount per share.
For example, a 6.5% preferred stock with a $25 par value would pay $1.625 per share annually, usually distributed in quarterly payments of approximately $0.41.
Unlike bond interest payments, companies can suspend preferred dividends at any time without triggering default. This makes preferred stock less risky for the issuing company but introduces dividend suspension risk for investors. However, most preferred securities include provisions that prohibit common stock dividends until all preferred dividends are current.
Preferred shares typically trade on major exchanges like the NYSE and NASDAQ, providing liquidity similar to common stocks. Prices fluctuate based on interest rate movements, credit quality changes, and supply-demand dynamics in the preferred securities market.
Types of Preferred Securities
Understanding the different types of preferred stock helps investors match securities to their investment objectives and risk tolerance.
Cumulative Preferred Stock
Cumulative preferred shares accumulate unpaid dividends as obligations that must be paid before any common stock dividends. If a company suspends dividends for three quarters, it must pay those three quarters plus the current quarter before resuming common dividends. This feature provides stronger protection for income-focused investors.
When to Consider: You prioritize income stability and want protection against missed dividend payments during periods of company financial stress.
Non-Cumulative Preferred Stock
Non-cumulative preferred shares do not accumulate missed dividend payments. If the company skips a dividend, that payment is lost forever. While riskier for investors, non-cumulative preferreds often offer higher yields to compensate for this additional uncertainty.
When to Consider: You are willing to accept higher risk in exchange for potentially higher yields and believe the issuer has strong dividend payment reliability.
Convertible Preferred Stock
Convertible preferred shares can be exchanged for a specified number of common shares at the investor's discretion. This feature allows investors to participate in stock price appreciation while maintaining the stability and income of preferred stock. According to research from the National Bureau of Economic Research, convertible preferred securities provide a compelling risk-return profile during periods of equity market strength.
When to Consider: You want the income stability of preferred stock while retaining the option to participate in potential common stock appreciation.
Perpetual Preferred Stock
Perpetual preferred shares have no maturity date and pay dividends indefinitely unless called by the issuer. These securities behave similarly to bonds with very long maturities and are particularly sensitive to interest rate changes.
When to Consider: You seek a long-term income stream and are comfortable with interest rate risk and the possibility of holding the security indefinitely.
Callable Preferred Stock
Callable preferreds allow the issuing company to redeem shares at a predetermined price after a specified date. Companies typically exercise call options when interest rates decline, allowing them to refinance at lower rates. This creates reinvestment risk for investors who must find comparable yields in a lower-rate environment.
When to Consider: You understand call risk and are evaluating yield-to-call metrics rather than assuming perpetual ownership.
Participating Preferred Stock
Participating preferred shareholders receive their fixed dividend plus the opportunity to receive additional dividends if the company achieves predetermined financial goals. This structure combines income stability with performance-based upside potential.
When to Consider: You want preferred stock income protection combined with potential participation in company success beyond the fixed dividend rate.
Preferred Stock vs Common Stock
The key differences between preferred and common stock affect both returns and risks:
Dividend Priority
Preferred shareholders receive dividends before common shareholders. During financial difficulties, companies often maintain preferred dividends while suspending common stock dividends to preserve access to capital markets.
Voting Rights
Common shareholders typically vote on corporate matters including board elections and major transactions. Most preferred stockholders sacrifice voting rights in exchange for dividend priority, though some issues include voting rights that activate under specific conditions.
Price Volatility
Common stock prices reflect company performance, growth expectations, and broader market sentiment, leading to higher volatility. Preferred stock prices primarily respond to interest rate changes and credit quality, resulting in bond-like price stability.
Appreciation Potential
Common stock offers unlimited upside potential as company value grows. Preferred stock prices typically trade in a narrower range around par value, limiting capital appreciation in exchange for more predictable income.
Benefits and Limitations of Investing in Preferred Shares
Advantages
- Higher Yields: Preferred stocks typically yield 5-7%, more than investment-grade bonds from the same issuer, compensating investors for subordinated status in the capital structure.
- Stable Income: Fixed dividend payments provide predictable cash flow for investors focused on income generation, with quarterly distributions aligning well with retirement income needs.
- Lower Volatility: Preferred stocks generally experience less price volatility than common stocks, making them appropriate for conservative portfolios seeking equity exposure with reduced risk.
- Tax-Advantaged Dividends: Qualified dividend treatment often results in lower tax rates (15-20%) compared to bond interest taxed as ordinary income (up to 37%), though specific tax treatment depends on individual circumstances.
- Priority in Capital Structure: Higher claim priority than common stock provides some protection during financial distress, though preferred shareholders still rank below bondholders.
Limitations
- Interest Rate Risk: Preferred stock prices fall when interest rates rise. According to Federal Reserve research, a 1% interest rate increase typically causes preferred stock prices to decline by 5-8%.
- Credit Risk: Preferred shareholders face the risk that the issuing company may suspend dividends or default. While preferred dividends are not contractually obligated like bond interest, suspension damages company credibility and limits access to capital.
- Call Risk: Companies often call preferred shares when interest rates fall, forcing investors to reinvest proceeds at lower yields. Understanding call provisions and yield-to-call metrics helps investors assess this risk.
- Liquidity Risk: Some preferred issues trade infrequently, particularly those from smaller companies or regional banks. Wide bid-ask spreads can increase transaction costs for investors.
- Limited Upside: Unlike common stock, preferred shares cap appreciation potential around par value plus accrued dividends. Investors sacrifice growth potential for income stability.
Ideal For:
Income-focused investors seeking yields higher than bonds with less volatility than common stocks, particularly those in moderate-to-high tax brackets who benefit from qualified dividend treatment.
Are Preferred Stocks Right for You?
Answer 5 quick questions to receive a personalized assessment of whether preferred stocks align with your investment profile.
Tax Implications of Preferred Dividends
Tax treatment significantly affects after-tax returns from preferred stock investments. According to Internal Revenue Service guidance, qualified dividend treatment applies when preferred shares meet specific holding period requirements.
Qualified Dividend Treatment
Preferred dividends meeting IRS criteria receive preferential tax rates, currently 0%, 15%, or 20% depending on income level. This compares favorably to ordinary income tax rates ranging up to 37% on bond interest.
Holding Period Requirements
To qualify for preferential treatment, investors must hold preferred shares for at least 90 days during the 181-day period beginning 90 days before the ex-dividend date. Frequent trading may disqualify dividends from preferential treatment.
Tax Comparison Example
| Income Type | Annual Income | Tax Rate | After-Tax Income | Effective Yield |
|---|---|---|---|---|
| Preferred Stock (QDI) | $1,000 | 20% | $800 | 6.4% |
| Corporate Bond | $1,000 | 37% | $630 | 5.0% |
| Tax Advantage | - | - | +$170 | +1.4% |
Example assumes investor in 37% federal tax bracket. Actual tax treatment varies based on individual circumstances. State taxes not included.
Non-Qualified Dividends
Some preferred securities, particularly those from REITs or foreign corporations, generate non-qualified dividends taxed at ordinary income rates. Review offering documents to understand the expected tax treatment.
Consult with a tax professional to understand how preferred stock investments affect your specific tax situation, as rules change and individual circumstances vary.
How to Evaluate Preferred Securities
Successful preferred stock investing requires careful evaluation of several key factors:
Credit Quality
Review issuer credit ratings from agencies like Moody's, S&P, and Fitch. Higher-rated securities offer lower yields but greater payment certainty. Financial sector preferreds often receive ratings one or two notches below the issuer's senior debt.
Yield Analysis
Compare yield-to-call rather than current yield for callable preferreds. Calculate the effective yield assuming the company calls shares at the earliest opportunity to understand potential returns.
Call Protection
Evaluate call provisions and call dates. Longer call protection provides more certainty about income duration, particularly valuable when purchasing preferreds at premiums to par value.
Dividend Coverage
Analyze the company's ability to maintain dividend payments through various economic scenarios. Review financial statements, earnings stability, and dividend coverage ratios.
Liquidity
Check average daily trading volume and bid-ask spreads. Higher trading volumes and tighter spreads reduce transaction costs and provide flexibility to adjust positions.
Sector Concentration
Financial institutions, utilities, and REITs dominate the preferred securities market. Understand sector-specific risks, particularly regulatory changes affecting banks and insurance companies.
Red Flags When Evaluating Preferred Securities
Identifying warning signs helps investors avoid problematic preferred stock investments:
Below-Investment-Grade Ratings
Preferred securities rated BB+ or lower carry significantly higher credit risk. While yields may appear attractive, the elevated risk of dividend suspension or default may not justify the additional return.
History of Suspended Dividends
Companies that have suspended preferred dividends in the past demonstrate higher willingness to prioritize other stakeholders over preferred shareholders during financial stress. Review dividend payment history before investing.
Trading Far Below Par Value
When preferred shares trade significantly below their $25 par value, markets are signaling concerns about the issuer's credit quality or ability to maintain dividends. Investigate the underlying reasons before purchasing distressed preferreds.
Lack of Call Protection
Preferreds callable immediately or within a short timeframe expose investors to reinvestment risk without compensation. Seek issues with at least 3-5 years of call protection, particularly when purchasing above par value.
Deteriorating Issuer Fundamentals
Monitor issuer financial health through quarterly earnings reports and credit rating updates. Declining earnings, rising leverage, or credit rating downgrades signal increasing risk of dividend suspension.
Unusual Terms or Provisions
Non-standard features like payment-in-kind (PIK) provisions, contingent conversion terms, or unusual call provisions may indicate elevated risk. Read offering documents carefully to understand all terms before investing.
How to Invest in Preferred Stock
Investors can access preferred securities through several approaches, each with distinct advantages:
Individual Preferred Shares
Purchase preferred stock directly through brokerage accounts, similar to buying common stock. Individual preferreds trade on major exchanges with standard par values of $25 per share. This approach allows precise selection of specific issuers, yields, and features but requires research and diversification management.
Minimum Investment: Typically $25-$1,000 depending on share price and position size goals.
Preferred Stock ETFs
Exchange-traded funds provide instant diversification across dozens or hundreds of preferred securities. ETFs like iShares Preferred and Income Securities ETF (PFF) or Invesco Preferred ETF (PGX) offer professional management, daily liquidity, and automatic rebalancing. Consider expense ratios and holdings concentration when evaluating ETF options.
Minimum Investment: One share of the ETF, typically $30-$40.
Preferred Stock Mutual Funds
Actively managed mutual funds invest in preferred securities with professional oversight. Funds may focus on specific sectors, credit qualities, or strategies. Mutual funds typically charge higher fees than ETFs but may provide active risk management and credit analysis.
Minimum Investment: Varies widely, typically $1,000-$3,000 for retail investors.
Key Trading Considerations
- Preferred shares are exchange-listed and trade during regular market hours
- Review ex-dividend dates to ensure eligibility for upcoming dividend payments
- Monitor call dates to understand when issuers may redeem shares
- Check daily trading volume to assess liquidity before placing large orders
- Use limit orders rather than market orders to control execution prices
Need help determining the right approach for your situation? Explore our investment management services to evaluate preferred securities within your overall portfolio strategy.
How Preferred Stocks Have Performed During Market Events
Understanding preferred stock behavior during historical market stress helps investors set appropriate expectations:
2008 Financial Crisis
Preferred securities experienced significant volatility during the 2008-2009 financial crisis, particularly those issued by banks and financial institutions. Many companies suspended dividends to preserve capital, and preferred share prices declined sharply. However, most investment-grade preferreds from large banks eventually resumed dividend payments as institutions stabilized.
Key Takeaway: Credit quality matters significantly during systemic financial stress. Investment-grade preferreds from well-capitalized institutions demonstrated better resilience than lower-rated issues.
2020 Pandemic Market Disruption
Preferred stocks declined in March 2020 alongside other risk assets but recovered more quickly than common stocks. Most issuers maintained dividend payments, reflecting stronger balance sheets and regulatory capital requirements implemented after 2008. Financial sector preferreds benefited from Federal Reserve liquidity support and banking system stability measures.
Key Takeaway: Preferred stocks demonstrated improved resilience compared to 2008, reflecting enhanced issuer credit quality and regulatory reforms in the banking sector.
2022 Interest Rate Hiking Cycle
As the Federal Reserve raised interest rates aggressively in 2022 to combat inflation, preferred stock prices declined in line with bond prices. Fixed-rate preferreds experienced larger price declines than floating-rate issues. However, dividend payments generally continued, and investors who held to maturity or call dates experienced no permanent capital loss.
Key Takeaway: Interest rate risk remains a primary driver of preferred stock price volatility. Investors should understand duration and consider yield-to-call when evaluating purchase prices relative to par value.
When to Consult a Financial Advisor
Preferred securities can play valuable roles in diversified portfolios, but determining appropriate allocations requires expertise in fixed-income analysis, tax planning, and portfolio construction.
Consider working with a financial advisor when evaluating preferred stock investments as part of a comprehensive financial plan. Advisors help assess whether preferred securities align with your income needs, risk tolerance, and overall investment strategy.
At Bogart Wealth, our advisors provide objective guidance on preferred securities and other fixed-income investments. We analyze individual securities, evaluate risks specific to your situation, and integrate preferred stocks into portfolios designed to meet your long-term financial objectives.
Understanding preferred securities requires analyzing multiple factors including yields, credit quality, tax implications, and how these investments interact with other portfolio holdings. Professional guidance ensures you make informed decisions aligned with your financial goals.
Frequently Asked Questions
Are preferred stock dividends guaranteed?
No, preferred stock dividends are not legally guaranteed like bond interest payments. Companies can suspend preferred dividends at any time without triggering default, though cumulative preferred shares require companies to pay missed dividends before resuming common stock dividends. Most companies maintain preferred dividends to preserve access to capital markets and avoid damaging their reputation with investors.
Can I sell preferred stock anytime like common stock?
Yes, preferred securities trade on major exchanges throughout the trading day, providing liquidity similar to common stocks. However, some preferred issues trade less frequently than common shares, particularly those from smaller companies or regional banks. Check average trading volume and bid-ask spreads before purchasing to ensure adequate liquidity for your investment timeline.
How does preferred stock perform during recessions?
Preferred stock typically experiences less price volatility than common stock during economic downturns but faces greater risk than bonds. Financial sector preferreds, which dominate the market, are particularly sensitive to banking stress. Credit quality becomes paramount during recessions, as weaker issuers may suspend dividends. Investment-grade preferreds from large, regulated financial institutions tend to demonstrate more resilience during economic uncertainty.
What happens to preferred stock if the company is sold?
In an acquisition, preferred stockholders typically receive payment according to their liquidation preferences specified in the offering documents. Most preferreds receive par value plus accrued dividends before common shareholders are paid. The acquisition agreement determines whether preferred shares are redeemed for cash, exchanged for acquiring company securities, or remain outstanding under new ownership. Review offering documents to understand the specific rights your preferred shares carry in change-of-control situations.
