Preferred stocks are a special type of stock that pay a fixed dividend and have no voting rights. Preferred stocks combine aspects of common stocks and bonds into one security, including regular income and ownership of the company. Investors buy preferred stocks to boost their income and also get certain tax benefits.

This is how preferred stocks work

Preferred stocks are often described as hybrid securities that have both characteristics Common stock and bind. It combines the stable and constant income payments of bonds with the benefits of stock ownership of common stocks, including the possibility that the stocks will appreciate in value over time.

Preferred Stocks vs. Bonds

Preferred stocks offer constant and regular payments in the form of dividends that are similar to interest payments on bonds. Like bonds, preferred shares are issued with a fixed face value, called the face value. The nominal value is used to calculate the dividend payments and is not related to the stock exchange price of the preferred share.

Unlike bonds, preferred stocks are not debts that must be paid back. Income from preference shares is given preferential tax treatment because qualifying dividends can be taxed at a lower rate than bond interest.

Unlike most bond coupon payments, dividends on preferred stocks are not guaranteed. When a company’s profits plummet or are in the red and lose money, the company can reduce or even stop paying dividends. Common stock dividends are reduced or eliminated before preferred stock dividends, although in certain cases even preferred stock dividends may be reduced or eliminated.

The priority of preferred stock over common stock extends to bankruptcy as well. When a company goes bankrupt and goes into liquidation, the bondholders are repaid first out of the remaining assets, followed by the preferred stockholders. Common shareholders are last in line, though they are usually wiped out in bankruptcy.

Common stock vs. preferred stock

Common stock and preferred stock give owners ownership of a company. You are probably familiar with common stocks, which can provide voting rights and even pay dividends. Preferred stocks offer more regular, scheduled dividend payments, which may be attractive to some investors, but they may not offer the same voting rights or potential for value growth over time.

With common stocks, you have the potential for unlimited upside: there is no limit to how high a stock price can go. With preferred stocks, your profits are more limited. This is because the prices of preferred stocks, like the prices of bonds, change slowly and are tied to market rates.

However, preferred stocks offer more stability and less risk than common stocks. While your dividend payments are not guaranteed, they take precedence over common stock dividends and can even be repaid if a company can’t afford them at some point. Preferred stockholders also come before common stockholders, but after bondholders in receiving payments when a company goes bankrupt.

It’s also worth noting that preferred stocks are redeemable in the same way as common stocks. After a certain date, the company can withdraw preferred shares. This can be done at face value or at a slightly higher call price. Both of these may differ from the market price you paid for the preferred share.

A company can recall and reissue a preferred stock to adjust the dividend payment to reflect current interest rates. Corporations can recall and reissue bonds for similar reasons.

Preferred shares can be converted into common shares

If you own preferred stock, you can take advantage of some capital appreciation by converting them into common stock. Not every company offers convertible stocks, but if you have a choice, you may be able to convert your preferred stock into common stock at a special price called a conversation ratio.

Preferred stock conversion ratio

For example, your preferred stock could have an exchange ratio of 5.5. If you choose to trade preferred shares, you will receive 5.5 common shares.

Just because you can convert a preferred stock to common stock doesn’t mean it is profitable. Before you can convert your preferred share, you must check the conversion price. To do this, divide the nominal value of the preferred share by the exchange ratio. If the resulting number is not equal to or higher than the current common stock price, you will lose money when you convert your stock. This is known as the conversion bonus.

In the example above, if you bought a preferred stock for $ 75, the conversion price would be $ 13.64 ($ 75 / 5.5). To receive any capital gain from the conversion, the stock must trade above this price. If it trades at $ 10 a share, your $ 75 share will make you $ 55 of common stock. In this case, the conversion premium is 20%, calculated using the following formula: [par value – (current common stock price x conversion ratio)] / 100.

You can also factor in the loss or difference in dividend income that comes with switching to common stock.

Preferred Stock Trading

Preferred stocks can be traded on the secondary market like common stocks. But just because of it can being sold does not mean you will get the same amount that you paid for it. Although the prices of preferred stocks are more stable than the prices of common stocks, they do not always correspond to par.

In addition, the resale value of convertible preference shares may be linked to their conversion premiums. When preferred stock has a low premium (or no premium), its value may go up like its common stock. If it has a high conversion premium, meaning it is not profitable to convert its shares, it can trade with a price consistency similar to a bond.

Preferred Stock Dividends

Investors often choose preferred stocks for their regular dividend payments. Since 1900, preferred stocks have had average annual returns of over 7%mostly from dividend payments. It is important to note, however, that although dividends are paid to preferred shareholders before common shareholders, dividends are not necessarily guaranteed.

This is in contrast to interest payments on bonds. However, if a company is unwilling or unable to pay a dividend on a preferred stock in a given quarter, you may be eligible for a back payment. That depends on whether your preferred stocks offer cumulative or non-cumulative dividends.

Cumulative vs. non-cumulative dividends

Preferred stock dividends can be cumulative or non-cumulative. With accumulated dividends, the company can pay the dividend at a later date if it cannot make the dividend payments as planned. These dividends accumulate and are paid out later when the company can afford it.

Non-cumulative dividends, on the other hand, can be neglected with impunity. If a company decides it can’t pay a dividend, it can skip paying that dividend.

Before buying any preferred stock, consider whether you are okay with no dividend payments, and with non-cumulative dividends, realize that you may not receive any dividends at all.

Dividend yield on preferred stocks

Dividend yield is a concept that will help you understand the relative value and return you can get from preferred stock dividends. Par value is key to understanding preferred stock dividend yields

Because the par values ​​of the preferred stock are fixed and not changing, the dividend yields on preferred stocks are more static and less variable than the dividend yields on common stocks. You can calculate the dividend yield on a preferred stock by dividing the annual dividend payment by the par value.

If a preferred stock has a par value of $ 100 and pays an annual dividend of $ 5 per share, the dividend yield is 5%.

Since nominal values ​​are not the same as trading values, you must also pay attention to the stock exchange price of the preferred shares. If the preferred stock from the example above was trading at $ 110, its effective dividend yield would drop to 4.5%.

Why Buy Preferred Stock?

Depending on your investment goals, preferred stocks can be a good addition to your portfolio. The main benefits of preferred stocks include:

• Higher dividends. Generally speaking, you can receive higher regular dividends with preferred stocks. The payouts are also usually higher than with a bond because you are taking on a higher risk.
• Preferential access to assets. If the company goes bankrupt, the preferred stockholders will come before the common stockholders, but still behind the bondholders.
• Potential premium from redeemable stocks. Since preference shares are redeemable, the company can buy them back. If the callable price is above par, you may get more than you paid for the preferred stock.
• Ability to convert preference shares into common shares. When you buy convertible stocks, you can exchange your preferred stock for common stock. If the value of the common stock increases dramatically, you can convert your shares and benefit from their appreciation while investing in a less risky asset.

When choosing to invest in preferred stocks, you should consider your overall portfolio goals. Preferred stocks come with high dividend payments but limited growth potential and can be reclaimed by a company with no or short notice. Although preferred stocks offer more dividend security than common stocks, dividends are still not guaranteed.

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