Preferred Stocks: What is it, and how does it work?
Preferred stock is a hybrid security that combines the features of a stock and a bond. Due to its "hybrid status," it is considered to be less risky than regular stocks but riskier than bonds.
Investing is an easy task but making sure that your investments fit you and would benefit you in the long term is the more challenging part. As a beginning investor, it is easy to think that all stocks are the same, but they are not. Each stock is different from one another. Some stocks are more profitable than others, some stocks are more advantageous, and some are more secure.
As an investor, the duty and responsibility to check your investments lies on you alone. You need to smartly manage your portfolio. If you plan to enter the stock market and purchase some stocks, do not just randomly pick penny stocks or hastily choose stocks of famous companies. Do not buy stocks "directly." Before buying stocks, you need to assess their profitability, potential, dividends and etc. Before buying stocks, you need to see whether it is common or preferred.
The main types of stocks an investor would encounter in the stock market are common stocks and preferred stocks. Most of the time, you would be choosing between them. The two types of stock share some similarities, but they also have differences. One offers some perks that the other does not have and vice versa. So, buying any of them is acceptable, but there are reasons why one is called "common" and the other as "preferred." These reasons are essential in making an informed investment decision.
To guide and help you in making that informed investment decision, we would feature preferred stocks. In this article, you will know why it is called "preferred," its advantages, benefits, etc.
What is a preferred stock?
Like a regular stock (common stock), a preferred stock also represents partial company ownership. But the word "preferred" on it is not just for show since it has some advantages and additional protection.
Preferred stock is stock seen as a hybrid between common stock and a bond. This "hybrid status" makes it an investment that is less risky than common stocks but riskier than bonds.
Preferred stock combines the debt feature, which is commonly associated with bonds. This type of stock pays regular fixed dividends while maintaining its potential for future appreciation. In addition, preferred stocks are prioritized over common stocks when giving dividends. These characteristics of preferred stock make it an appealing investment for investors who want stability while holding some possible cash flow
Aside from the prioritization in dividends and fixed income, preferred stockholders also enjoy a more secured investment. In a company's capital structure, preferred stocks rank above common stocks but below bonds. This position means that during the liquidation of assets, preferred stockholders will be prioritized over common stockholders. If a company can no longer meet their obligation to lenders and thus become insolvent, they need to sell their assets to pay their outstanding debts. After this, the remaining assets will be used to pay creditors and stockholders. In this event, preferred stockholders have a higher claim than common stockholders, which are last in line; thus, the former has a higher chance to secure compensation from the company.
But these benefits are not free, it comes at a cost. Holders of preferred stocks have limited rights, and voting rights are not included in these rights. This means that preferred stockholders have no voice in the election of the company's board of directors nor in the corporate policy.
How does a preferred stock work?
Preferred stock combines the characteristics of common stock and a bond. It has stable and regular income quality associated with bonds. It also has the equity ownership and potential price appreciation typical to common stocks.
Characteristics of a preferred stock
Preferred stocks share some similarities with both common stocks and bonds. These similarities make preferred stocks look like a hybrid between the two. Some of the characteristics of preferred stock are the following:
1. Pay fixed dividends on a regular schedule
2. Prioritized to receive dividends first before common stock
3. Like other securities with fixed income, preferred stocks have an inverse relationship with interest rates
4. Has a "par value" similar to bonds. These can be commonly redeemed for $25.
5. The issues can repurchase it after a certain period (five years most of the time)
6. Positioned above common stocks in the event of asset liquidation
7. Has limited rights
8. Has no power to vote in the election of the company's board of directors and policies.
Other features that make preferred stocks rewarding
Preferred stocks have qualities and features that cannot be found on either common stock or a bond. These qualities are privileges that make preferred stocks special but unusual for classes with fixed-income at the same time. However, these qualities make a preferred stock stand out. These characteristics contribute to the flexibility of preferred stocks that are not seen on fixed-income securities like bonds. Also, preferred stocks typically make higher yields.
1. Preferred stocks are often perpetual. Unlike other fixed-income securities that have a well-defined term, preferred stocks can be perpetual. Unless the company repurchases the stocks, they will remain outstanding indefinitely. Therefore, there is no fixed date regarding the payment of the invested capital.
2. Preferred stocks can be cumulative. This is a unique and flexible feature that works for both the issuer and the preferred stockholder. Companies use this when they are unable to pay dividends. They would use this feature to postpone the payment but not totally skip it. Therefore, a company may delay paying dividends, but they must add it to the next dividend payment.
3. Preferred stocks can be convertible. This is a feature that allows the conversion of preferred stocks. In turn, this gives an opportunity for preferred stockholders to convert their preferred stock into a predetermined number of common stocks at a predetermined price.
4. Preferred stocks can be exchangeable. This quality is like the convertibility in the third item; the only difference is that instead of common stocks, the preferred stockholders have the option to exchange the preferred stocks they have for other types of securities.
Bonds vs. Common stocks vs. Preferred stocks.
With the treatment of preferred stocks as a hybrid between bonds and common stocks, it is imperative how the three differ.
Many investors are attracted to preferred stocks as it offers a steady and a higher payout than bonds and common stocks. But choosing it means letting go of the upside potential of common stocks and the safety associated with bonds.
Companies issue preferred stocks due to the same reasons why they issue bonds. They need capital that would fund their further growth or expansion. And bonds and preferred stocks are convenient ways to raise their needed amount. Upon the issuance, many investors would buy preferred stocks as it typically offers a higher yield.
Now, despite the higher yield offered by preferred stocks, not all investors prefer them over bonds. The reason for this is not the rewards but the risks. Bonds is more safety than preferred stocks as it has lower risks. Below is a further explanation for the risks associated with the three.
Bonds. Bonds are the safest way to invest in a publicly-traded company. It is a fixed-income security that provides stable cash flow while entertaining lower risks. In the event of company liquidation, bondholders take precedence over preferred and common stockholders
Preferred Stocks. Preferred stocks are positioned between bonds and common stocks. It entertains more risks compared to bonds in exchange for more rewards. But these rewards are limited. If the company goes insolvent and the assets become liquidated, preferred stockholders' claims are prioritized over common stockholders but are attended to after the payment of bondholders' claims.
Common Stocks. Common stock is the riskiest of the three, but it also has the potential to be the most rewarding. Unlike preferred stocks with a profit capped at the dividend payout, the profit for common stocks is not limited. In the event of company liquidation, common stockholders are last in line to receive compensation (so they are more likely to receive lower or nothing at all)
Who buys preferred stocks?
Preferred stocks can assume different forms, the features mentioned above are the typical features that can be observed to preferred stocks. Most of the times, preferred stocks issued by companies have characteristics that are a combination of the common features.
Investors can purchase these stocks through their brokerage accounts. But most of the times, the main buyers of preferred stocks are big institutions who enjoy some tax advantages not available for individual investors.
How to buy preferred stocks?
Similar to common stocks, preferred stocks are also traded on stock exchanges. This means that buying them is also relatively easy.Like common stocks. you can buy preferred stocks through any brokerage account. While buying preferred stocks, be mindful of the ticker symbols since preferred stocks have different symbols than their common stock counterpart.