Preferred Stocks: A Complete Guide for Income-Focused Investors
Preferred Stocks are a unique type of investment that combines some characteristics of stocks and bonds. They can be attractive to investors who want regular dividend income while still having an ownership interest in a company. Unlike common stockholders, preferred stockholders generally receive dividend payments before common shareholders and have a higher claim than common shareholders if the company is liquidated. However, preferred stocks also come with risks, including interest-rate risk, credit risk, limited growth potential, and the possibility that dividends may be suspended.
Understanding how preferred stocks work is important before adding them to an investment portfolio. Each preferred stock issue can have different terms, dividend rates, call provisions, conversion features, and payment protections. Therefore, investors should evaluate the specific security rather than assuming all preferred stocks work exactly the same way.
This guide explains what preferred stocks are, how they work, their major types, advantages and disadvantages, how they compare with common stocks and bonds, and what investors should consider before buying them.
What Are Preferred Stocks?
Preferred stocks are a class of company shares that usually provide investors with a priority claim over common shareholders when it comes to dividends and liquidation proceeds.
Companies issue preferred stocks to raise capital. Investors who purchase these shares become shareholders, but preferred shareholders typically receive different rights from common shareholders.
One of the main attractions is dividend priority. If a company declares dividends, preferred shareholders generally have priority over common shareholders. In a liquidation, preferred shareholders generally rank ahead of common shareholders but behind creditors and bondholders.
Preferred stocks are often described as hybrid securities because they have characteristics of both stocks and bonds. They are equity because they represent an ownership interest in a company, but their income characteristics can resemble bonds because many preferred shares pay a stated dividend.
However, preferred stocks are not the same as bonds. A bond represents debt, while preferred stock represents equity. Bondholders generally have a higher claim on company assets than preferred shareholders.
How Do Preferred Stocks Work?
When a company issues preferred shares, it establishes specific terms for that particular series. These terms can include the dividend rate, par value, payment schedule, whether dividends are cumulative, whether shares can be converted into common stock, and whether the company can redeem the shares.
For example, imagine a preferred stock with a $25 par value and a 6% annual dividend rate.
The annual dividend per share would be:
$25 × 6% = $1.50 per year
If dividends are paid quarterly, the investor could receive:
$1.50 ÷ 4 = $0.375 per share per quarter
If an investor owns 500 shares, the annual dividend would be:
500 × $1.50 = $750
This example assumes the dividend is declared and paid according to the terms of the preferred security.
It is important to remember that preferred dividends are not automatically equivalent to interest payments on bonds. The exact rights depend on the security’s terms, and dividends can potentially be suspended.
Preferred Stocks vs. Common Stocks
Preferred and common stocks are both forms of equity, but they are designed with different characteristics.
Common stockholders generally have voting rights and may benefit significantly if the company’s value increases. They may also receive dividends, but common dividends typically come after preferred dividends.
Preferred stockholders generally receive priority for dividends and liquidation claims compared with common shareholders. However, they commonly have limited or no voting rights and may have less opportunity for capital appreciation.
| Feature | Preferred Stock | Common Stock |
|---|---|---|
| Dividend priority | Higher | Lower |
| Voting rights | Usually limited or none | Usually available |
| Income | Often more predictable | Usually variable |
| Growth potential | Generally lower | Generally higher |
| Liquidation priority | Ahead of common | Behind preferred |
| Risk level | Usually between common stock and debt | Generally higher than preferred |
| Conversion feature | Sometimes available | Not normally applicable |
Investor.gov explains that preferred shareholders generally receive dividends before common shareholders and have priority over common shareholders if a company is liquidated.
Why Do Companies Issue Preferred Stocks?
Companies can use preferred stocks as a way to raise capital without issuing additional debt.
There are several reasons a company may choose preferred stock.
Raising Capital
A company can sell preferred shares to investors and use the proceeds for business operations, expansion, acquisitions, or other corporate purposes.
Managing Capital Structure
Preferred stock can provide another financing option between traditional debt and common equity.
Attracting Income-Focused Investors
Because many preferred stocks offer stated dividend rates, they can appeal to investors who prioritize income.
Maintaining Common Shareholder Control
Preferred shares frequently have limited voting rights. This can allow a company to raise capital without giving preferred shareholders the same governance rights as common shareholders.
Main Features of Preferred Stocks
Preferred stocks can have several features that make them different from ordinary shares.
Fixed Dividend Rate
Many preferred shares pay a fixed dividend based on their stated or par value.
For example, a preferred stock might have a $25 par value and a 5.5% dividend rate.
Its annual dividend would be:
$25 × 5.5% = $1.375 per share
The actual yield an investor receives based on the purchase price can be different.
Dividend Priority
Preferred shareholders generally have priority over common shareholders when dividends are declared.
This does not mean preferred dividends are guaranteed. The precise protection depends on the terms of the preferred issue.
Liquidation Preference
If a company is liquidated, preferred shareholders generally rank above common shareholders but below creditors and other senior obligations.
This distinction is important because preferred stock is still equity rather than debt.
Limited Voting Rights
Preferred shareholders often do not have the same voting rights as common shareholders.
This is one of the major trade-offs. Investors may receive more predictable income characteristics but give up some influence over corporate decisions.
Call Provisions
Some preferred stocks can be redeemed by the issuing company after a specified date.
This is called a call feature.
A company might redeem shares at a predetermined price, which can affect an investor’s potential return.
Conversion Feature
Some preferred shares can be converted into common shares under specific conditions.
Convertible preferred stock may provide investors with an opportunity to benefit from increases in the common stock price, although the conversion terms can vary considerably.
Types of Preferred Stocks
Not all preferred stocks are identical. Investors should understand the major types before investing.
Cumulative Preferred Stock
Cumulative preferred stock provides additional protection concerning missed dividends.
If the company suspends a cumulative preferred dividend, the unpaid amount generally accumulates. Before common shareholders can receive dividends, the accumulated preferred dividends generally need to be addressed according to the security’s terms.
This can make cumulative preferred stock attractive to income-oriented investors.
However, cumulative does not mean risk-free. A company experiencing serious financial difficulties may still create significant losses for shareholders.
Non-Cumulative Preferred Stock
With non-cumulative preferred stock, skipped dividends generally do not accumulate in the same way.
If the company suspends a dividend, the investor may not have a right to recover the missed payment later.
Because of this difference, investors should carefully examine whether a preferred issue is cumulative or non-cumulative.
Convertible Preferred Stock
Convertible preferred stock gives investors the ability, under specified terms, to convert preferred shares into common shares.
This can provide additional upside potential if the company’s common stock performs strongly.
However, conversion ratios, conversion prices, dates, and other conditions vary by issue.
Callable Preferred Stock
Callable preferred stock allows the issuer to redeem the shares under specified conditions.
Call risk matters because an investor may purchase a preferred share at a premium and later have it redeemed at the stated call price.
Participating Preferred Stock
Participating preferred stock can provide shareholders with additional participation in company profits beyond their stated preferred dividend, depending on the security’s terms.
These securities can have more complex structures, so investors should read the offering documents carefully.
Adjustable-Rate Preferred Stock
Some preferred stocks have dividends that can change according to a specified formula or reference rate.
Adjustable-rate structures can behave differently from fixed-rate preferred stocks when interest rates change.
FINRA materials identify several preferred stock structures, including cumulative, non-cumulative, participating, nonparticipating, convertible, callable, sinking-fund, and adjustable-rate preferred stock.
Benefits of Preferred Stocks
Preferred stocks can offer several potential advantages.
1. Potential for Regular Income
One of the biggest reasons investors consider preferred stocks is dividend income.
Many preferred shares have stated dividend rates, which can make their cash-flow characteristics more predictable than common stocks.
2. Dividend Priority
Preferred shareholders generally receive priority over common shareholders when dividends are paid.
This can make preferred stocks attractive to investors who place greater emphasis on income.
3. Higher Claim Than Common Stock
In a liquidation, preferred shareholders generally rank ahead of common shareholders.
However, they remain behind creditors and many forms of debt.
4. Portfolio Diversification
Preferred stocks can provide another type of security within a diversified portfolio.
Instead of relying entirely on common stocks or bonds, investors may use preferred securities as one component of a broader asset allocation strategy.
5. Potentially Lower Volatility Than Common Stock
Some preferred stocks may experience less price volatility than common shares because their value is heavily influenced by their dividend characteristics.
That does not mean they are stable in every market environment. Interest rates and changes in the issuer’s financial condition can cause significant price movements.
Risks of Preferred Stocks
Preferred stocks also have important risks. Investors should understand these risks before purchasing them.
Interest Rate Risk
Preferred stocks with fixed dividend rates can be sensitive to interest-rate movements.
When market interest rates rise, existing fixed-rate preferred shares may become less attractive relative to newer securities offering higher yields. Their market prices may therefore decline.
When interest rates fall, fixed-rate preferred shares may become more attractive, potentially supporting their market value.
This relationship is one reason preferred stocks can behave somewhat like bonds.
Credit Risk
Preferred shareholders depend on the financial health of the issuing company.
If the company experiences financial difficulties, the preferred stock price can fall and dividends may be reduced or suspended.
A financially weak issuer can create significant losses even when the preferred stock has a high stated dividend.
Dividend Suspension Risk
Preferred dividends are not identical to legally required bond interest payments.
Depending on the terms, a company may be able to suspend preferred dividends without entering the same type of default associated with missed debt payments.
This is particularly important for investors who depend on investment income for regular expenses.
Call Risk
A callable preferred stock can be redeemed by the company.
If an investor bought shares below the call price, redemption may produce a gain. But if shares were purchased at a premium, the investor could experience a loss when the company calls them.
Limited Capital Growth
Preferred stocks generally have less capital appreciation potential than common stocks.
Common shareholders can potentially benefit significantly from business growth and rising earnings. Preferred shareholders may receive a relatively fixed dividend while giving up some of that upside.
Inflation Risk
If a preferred stock pays a fixed dividend, inflation can reduce the purchasing power of that income over time.
For long-term investors, this is an important consideration.
Liquidity Risk
Some preferred stocks trade less frequently than popular common stocks.
Lower trading volume can make it more difficult to buy or sell shares at the desired price.
Investors should examine trading volume and bid-ask spreads before placing an order.
Preferred Stocks vs. Bonds
Preferred stocks and bonds can both appeal to income-focused investors, but they have important differences.
| Feature | Preferred Stocks | Bonds |
|---|---|---|
| Security type | Equity | Debt |
| Income | Dividend | Interest |
| Claim in liquidation | Usually ahead of common stock | Generally ahead of shareholders |
| Voting rights | Usually limited | None |
| Maturity | Often none | Usually has maturity |
| Dividend/interest guarantee | Depends on terms; dividends may be suspended | Contractual interest obligation, subject to issuer’s ability to pay |
| Growth potential | Usually limited | Generally limited |
| Main risks | Credit, rates, call, liquidity | Credit, rates, inflation, liquidity |
Corporate bonds are debt obligations, and bondholders generally have priority over shareholders if a company faces bankruptcy or liquidation.
This means preferred stocks should not simply be treated as safer versions of common stocks or as substitutes for high-quality bonds.
How to Evaluate Preferred Stocks
Before purchasing a preferred stock, investors should review several factors.
1. Dividend Rate
Check the stated dividend rate and calculate the annual dividend per share.
2. Current Yield
The current yield depends on the market price.
For example:
Current Yield = Annual Dividend ÷ Current Market Price × 100
Suppose a preferred stock pays $1.50 per year and trades at $24.
The approximate current yield would be:
$1.50 ÷ $24 × 100 = 6.25%
The stated dividend rate and current yield are therefore not always the same.
3. Issuer Financial Strength
Review the financial health of the company issuing the preferred stock.
Look at revenue, cash flow, debt levels, profitability, credit quality, and the company’s ability to meet its financial obligations.
4. Cumulative or Non-Cumulative
Determine whether missed dividends accumulate.
This feature can materially change the risk profile of the security.
5. Call Date
Check whether the company can redeem the preferred shares and when the call provision becomes available.
6. Conversion Terms
If the preferred stock is convertible, understand the conversion ratio, conversion price, and conditions.
7. Market Price
Do not look only at the dividend rate.
A high stated dividend does not automatically mean a preferred stock is a good investment.
8. Liquidity
Check trading volume and bid-ask spreads before investing.
A security with limited liquidity may be harder to sell quickly at a favorable price.
How to Buy Preferred Stocks
Investors can generally purchase publicly traded preferred stocks through a brokerage account that provides access to the relevant market.
The basic process is straightforward.
Step 1: Define Your Investment Goal
Decide why you are considering preferred stocks.
Are you looking for income, diversification, or a combination of income and moderate price appreciation?
Step 2: Research Different Issues
Compare dividend rates, yields, issuer quality, payment features, call provisions, and conversion rights.
Step 3: Read the Security’s Terms
Do not rely only on a ticker symbol or dividend yield.
Read the relevant prospectus and security details to understand exactly what you are purchasing.
Step 4: Check the Market Price
Compare the current market price with the stated or par value.
A preferred stock trading significantly above or below par can have a very different risk and return profile.
Step 5: Consider Position Size
Avoid concentrating too much of a portfolio in a single preferred issue or issuer.
Diversification can reduce the impact of problems affecting one company.
Are Preferred Stocks Good for Income Investors?
Preferred stocks can be useful for some income-focused investors, but they are not appropriate for everyone.
An investor may consider preferred stocks when they want:
- Potentially regular dividend income
- Higher priority than common shareholders
- Exposure to a hybrid security
- Portfolio diversification
- Less dependence on common-stock price appreciation
However, investors should also be comfortable with:
- Dividend suspension risk
- Interest-rate sensitivity
- Credit risk
- Call risk
- Limited voting rights
- Limited growth potential
The right investment depends on the investor’s goals, time horizon, risk tolerance, and overall portfolio.
Example of a Preferred Stock Investment
Suppose an investor purchases 200 preferred shares with a $25 par value and a 6% dividend rate.
Annual dividend per share:
$25 × 6% = $1.50
Annual income:
200 × $1.50 = $300
If the investor paid $24 per share, the total investment would be:
200 × $24 = $4,800
The approximate current yield would be:
$300 ÷ $4,800 × 100 = 6.25%
This example demonstrates why investors should distinguish between the stated dividend rate and the yield based on the actual purchase price.
If the market price later rises to $27, the investor’s yield based on the original purchase price remains different from the yield someone purchasing at $27 would receive.
This is why preferred stock analysis should consider both income and market price.
Common Mistakes to Avoid
Focusing Only on High Yield
A high yield can sometimes indicate higher risk.
Investors should investigate why the yield is high before buying.
Assuming Preferred Dividends Are Guaranteed
Preferred dividends can have stronger protections than common dividends, but they are not the same as contractual bond interest.
Ignoring Interest Rates
Fixed-rate preferred stocks can be sensitive to changing interest rates.
Forgetting About Call Risk
A preferred stock trading above its redemption value can carry meaningful call risk.
Ignoring the Issuer
The quality of the company matters.
A high dividend from a financially weak issuer may not be attractive after considering the potential risks.
Putting Too Much Money Into One Issue
Concentration can increase portfolio risk.
Diversification across issuers and asset classes may help manage company-specific risk.
Frequently Asked Questions About Preferred Stocks
What are preferred stocks?
Preferred stocks are a type of equity security that generally gives investors priority over common shareholders for dividends and liquidation claims. They often have characteristics similar to both stocks and bonds.
Are preferred stocks safer than common stocks?
Preferred stocks generally have greater priority than common stocks for dividends and liquidation, but they are not risk-free. They remain subject to credit, interest-rate, liquidity, call, and dividend-suspension risks.
Do preferred stocks pay dividends?
Many preferred stocks pay dividends according to a stated rate or formula. However, the exact payment terms vary by security, and dividends are not necessarily guaranteed.
Do preferred shareholders have voting rights?
Preferred shareholders often have limited or no ordinary voting rights. The exact rights depend on the preferred stock’s terms.
Can preferred stocks lose value?
Yes. Preferred stocks trade in the market and their prices can fall because of rising interest rates, deteriorating company finances, market conditions, or other factors.
Can preferred stocks be converted into common stock?
Some preferred stocks are convertible, while others are not. Investors should check the specific security’s conversion terms.
What is cumulative preferred stock?
Cumulative preferred stock generally provides that unpaid preferred dividends accumulate according to the security’s terms. This can provide additional protection compared with non-cumulative preferred stock.
Are preferred stocks good for beginners?
Preferred stocks can be more complex than ordinary common stocks because each issue can have different terms. Beginners should understand the dividend structure, call provisions, credit risk, liquidity, and other features before investing.
Final Thoughts on Preferred Stocks
Preferred Stocks can be an interesting option for investors who want potential income and a higher claim than common shareholders. Their hybrid structure gives them characteristics associated with both equity and fixed-income investments.
The main attraction is usually dividend priority and potentially predictable income. However, investors should not confuse preferred stocks with guaranteed-income investments. Preferred shares can decline in value, dividends can potentially be suspended, and rising interest rates can negatively affect fixed-rate preferred securities.
The best approach is to evaluate each preferred issue individually. Look at the dividend rate, current yield, issuer’s financial strength, cumulative status, call provisions, conversion features, liquidity, and market price before investing.
Preferred stocks may have a useful role in a diversified portfolio, particularly for investors who prioritize income, but they should be selected based on overall financial goals and risk tolerance rather than dividend yield alone.
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