Preferred stocks supply steady dividends to investors — here's how to evaluate them for your portfolio

John Rambow

Nov 17, 2020, 05:05 IST

Preferred stocks supply steady dividends to investors — here's how to evaluate them for your portfolio

Preferred stock shares pay higher dividends and their prices are less volatile.seksan Mongkhonkhamsao/ Getty Images

Preferred stock is a type of equity (ownership) security issued by companies to raise money.
Preferred stocks pay a higher, fixed dividend than common stock, but their share prices don't appreciate as much as common shares do.
Preferreds are best for institutional investors or sophisticated individuals who want them for tax reasons and can weather the risk of the shares being recalled.

Publicly traded companies have a few ways to raise money. The usual methods include issuing common stock — part-ownership in a company that often rewards buyers with regular payments, called dividends — and selling corporate bonds, loans that come with contractual interest payments, and the full repayment when the bond finally matures.

And then there's a third option: preferred stock, which somewhat confusingly mashes up features of both common stock and bonds. The name's kind of a misnomer — preferred stock shares aren't "preferred" because they're extra-fancy. Nor are they "better" than common stock, except under limited circumstances and for certain types of investors.

If you're wondering whether preferred stocks are right for your portfolio, here's what you need to know.

What is preferred stock?

As with common stock, when you buy a share of preferred stock, you are buying a (small) part of the company. And also like common stock, you usually get a certain percentage of money on a regular basis — that's the dividend. The dividend comes from a portion of the company's profits, assuming there are any.

Unlike common stock, preferred stock comes with limited or no voting rights — you can't use your share to vote for the board of directors, or for or against other policies.

Because preferreds don't come with those voting rights, companies sometimes issue them instead of common stock to avoid diluting ownership. Preferred shares can be sold to qualified investors and employees by privately held companies as well as public ones; if the company goes public, any preferreds can then be bought and sold on a stock exchange.

The price of a preferred share goes up and down based on demand, like common stock. But that share price doesn't wander away too far from its par value — that is, its initial offering price. It generally moves in response to general interest rates, much like bond prices do.

That's because preferred stocks resemble bonds in a key way: The dividend they pay every quarter is fixed — similar to a bond's interest payment — unlike a common share dividend, which often fluctuates each quarter.

Although that flow isn't contractually guaranteed the way it is with bonds, companies generally feel obligated to give precedence to paying preferred dividends over common dividends.

How preferred stocks work

Getting to be ahead of common stockholders in the dividend line is only one of preferred shares' unique features.

Here are the basics of how preffered stocks work:

Preferred stock dividends are usually a lot higher than common-stock dividends, and their jumbo size is essentially the whole reason people buy them. The dividends, which are paid quarterly, are expressed as a percentage of their issued value (called "par"); this percentage is often called their coupon rate. For instance, a preferred stock issued at a par of $50 with a coupon of 6.75% will pay out about $0.84 a quarter, or $3.35 annually.
Most preferreds are callable, meaning that a company may decide to force investors to sell their shares back to them at the prevailing market price, plus some sort of premium.
Many preferreds are also convertible, meaning that a share can be changed into common stock. For instance, a stock's prospectus may say that one share of preferred can be changed into five shares of common stock once a certain date has passed. (In some cases, a company can even force preferred owners to make that conversion.)

What the "preferred" in preferred stock means

The price of a preferred share can fluctuate in daily trading, just like its common share counterpart. It can, and does, reflect what's happening to the company. But because most preferreds are callable, the upside is more limited, and their share price stays pretty close to par value, as noted earlier. The par value is usually akin to what a preferred share would buy in common stock.

So what's the preferred thing worth? It really only comes into play when the company's in trouble: Preferred shareholders always get their dividends before common shareholders if a company has serious financial problems affecting cash flow, or otherwise decides to suspend dividends. Creditors, employees, bondholders, and a few other groups are still ahead of them in the getting-paid line, though.

Of course, most companies make a strong effort to pay dividends through hell and high water. Suspending preferred share dividends is a pretty drastic step. One nice thing, though: when companies are able and willing to begin paying dividends again, they are obliged to start paying them on preferred shares before they can start paying them on common stock.

Who buys preferred stock?

Loading up on common stock makes sense for lots of different kinds of investors, but the market for preferreds is more limited.

Most preferred stock is bought by institutions and pension funds. They love the higher dividends and are better equipped to assess the risks, including the fact that preferreds are less liquid (easily sold) than common stock. Institutions also get special tax advantages from preferreds in some cases.

Because the dividends are taxed as capital gains if they are held longer, they may also make sense for income-oriented individual investors who'd otherwise buy bonds. That's because bond payments are interest, which is always taxed as normal income. In contrast, stock dividends qualify for a lower tax rate if you own them as a longer-term investment (longer than a year, usually).

Still, for most investors, preferreds' downsides outweigh their potential. They may pay out more than bonds do, but those dividends aren't guaranteed. And if they won't ever appreciate much in value the way common stock does, since a company would simply call them before that happens.

The financial takeaway

Preferreds aren't called that because they're so classy. They're preferred because their dividends have to be paid before those that would go to the common stockholders.

Preferred stock pays higher dividends than common stock, but its share price will never appreciate the way common stock might. So, the upside's more limited.

Preferreds are best for institutional investors or for more sophisticated individuals, who want them in their portfolio for tax reasons or for some other particular goal. Despite their advantages, they have several aspects to keep track of. Most individual investors don't need the hybrid features that preferreds are known for.