What Is Preferred Stock?

When most people think about buying “stock,” they’re thinking about common stock. But did you know that there’s another class of stock called preferred stock? Well, now you do. When you buy preferred stock, you’re investing in equities – but with some bond-like features. You lock in a dividend rate, much like you would with a bond or other fixed-income security. Let us explain.

Common vs. Preferred Stock

Most people will need to invest in the stock market if they’re going to save enough for retirement. But not all stock is created equal. When you buy common stock, your dividends can vary. One big difference between common and preferred stock? Preferred stock generally comes with a fixed dividend rate. Dividends to preferred shareholders are paid before dividends to common shareholders. Another difference is that if the company that issued the shares is liquidated, preferred stockholders will have access to the company’s assets before common stockholders. Owners of preferred stock are behind bondholders in line for company assets, but they’re ahead of owners of common stock. Sounds good, right?

But there’s a catch. With preferred stock, because you’re pretty much locking in your rate of return at the time of purchase, you won’t gain from company growth (in the form of higher dividends) like a common stockholder would. Your dividends could be deferred if the company can’t afford to pay shareholders. Plus, you don’t have voting rights as a preferred shareholder the way you would if you owned common stock. The good news is that the dividends from your preferred shares will receive the same favorable tax treatment that regular dividends receive.

Callable Preferred Stock

Many preferred shares are “callable.” A callable preferred stock is one that gives the company issuing the stock the option to “call” (revoke) the stock from the shareholder. A call provision usually kicks in after five years. It means that the issuer has the right to buy back your shares at face value. That leaves owners of callable preferred stock vulnerable to the whims of the stock issuer, who may wish to call the stock just when the shareholder would want to hang on to it.

Preferred Stock vs. Bonds

Torn between the potential returns of stock and and the predictability of bonds? You may be drawn to preferred stock. That’s because preferred stock combines traits of both stocks and bonds. You’ll get paid at a fairly fixed rate (as with bonds), but that rate will be higher than the rates on Treasury bonds (as with stocks).

A word of caution: bonds have one serious advantage over preferred stocks that’s worth mentioning. As with dividends on common stock, dividends on preferred stock aren’t guaranteed. A company may stop paying dividends if it falls on tough times. This can’t happen with a bond because a bond represents a contractual obligation between the company and the bondholder. So, if you need fixed income that’s really fixed, you’re probably better off with bonds than with preferred stock.

Non-callable bonds have another advantage over callable preferred stock, which is that the owner isn’t subject to a “call” from the issuer. If you want to keep a non-callable bond until maturity or until you deem it’s time to sell, you have the right to do so.

Risks of Preferred Stock

Preferred stock isn’t risk-free. For one thing, if interest rates rise, the value of preferred stock falls, just as with bonds. That’s because the opportunity cost of holding that preferred stock is higher once interest rates rise.

Another potential risk that comes with preferred stock is overexposure to certain industries. That’s why some investors choose to buy preferred stock funds, which buy preferred shares from companies across several industries. But even preferred stock Exchange Traded Funds (ETFs) may be heavily invested in financial sector companies, since issuing preferred stock is most common in that industry. That means less diversification and more risk.

Preferred stock can be a relatively expensive investment. Because the returns are a) higher than with bonds and b) fixed, fund managers charge more for the privilege of investing in “preferreds.” Investors in preferred stock also bear significant credit risk. The companies that issue preferred stock often do so for reasons that make them risky investments.

Dividends from preferred stock aren’t tax-deductible for the issuer, so the strongest companies with the best credit usually don’t issue preferred stock. Companies that do issue preferreds may do so because they’ve already taken on a lot of debt but still need to raise money. They may call those stocks when the company’s credit rating improves, leaving the investor high and dry.

Bottom Line

Preferred stocks offer some serious enticements: steady returns, tax advantages and higher yields. If you want to get in on the action, shop around for brokerages that offer competitive fees. As with any investment, you want to make sure your money is growing, not lining the pockets of your broker.

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