Preferred Stock
Preferred Stock: A Hybrid Investment with Benefits and Risks
Preferred stock is a type of equity security that represents ownership in a company but has characteristics of both equity and debt. It gives shareholders preference over common stockholders when it comes to dividends and assets in the event of liquidation. Preferred stock is often issued by companies seeking to raise capital while offering more attractive terms than common stock but without the obligations of debt financing.
Key Characteristics of Preferred Stock
Dividend Priority:
Preferred stockholders have a priority claim on dividends over common stockholders. This means that a company must pay dividends to preferred shareholders before it can pay dividends to common shareholders.
The dividend is usually set at a fixed rate, and the payments are typically made quarterly or annually. This makes preferred stock appealing to income-focused investors.
Fixed Dividend:
Preferred stock often pays a fixed dividend that is expressed as a percentage of the par value of the stock. For example, a preferred stock with a par value of $100 and a 5% dividend will pay $5 annually per share.
Unlike common stock, which may pay variable dividends based on the company’s profitability, preferred stock dividends are fixed and predictable.
Preference in Liquidation:
In the event of bankruptcy or liquidation, preferred shareholders have a higher claim on the company’s assets than common shareholders. This means that after creditors are paid, preferred shareholders receive any remaining funds before common shareholders.
However, preferred shareholders are subordinate to debt holders, such as bondholders.
No Voting Rights:
Preferred stockholders typically do not have voting rights in the company, meaning they do not participate in decisions such as electing the board of directors or approving mergers and acquisitions.
This distinguishes preferred stock from common stock, which usually carries voting rights.
Convertible Feature:
Some preferred stock is convertible, meaning it can be exchanged for a set number of common shares at a predetermined price. This provides potential upside for preferred shareholders if the company’s stock price increases significantly.
Callable Feature:
Callable preferred stock gives the issuing company the right to repurchase (or "call") the preferred shares at a predetermined price after a certain date. This can be advantageous for the company if interest rates fall, as it allows them to buy back the stock and issue new preferred stock at a lower dividend rate.
Cumulative vs. Non-Cumulative:
Cumulative preferred stock means that if a company skips a dividend payment, it must pay all accumulated dividends in the future before paying any dividends to common stockholders.
Non-cumulative preferred stock, on the other hand, does not require the company to make up missed dividends. If a dividend is skipped, it is permanently lost.
Advantages of Preferred Stock
Stable Income Stream:
Preferred stock is often attractive to investors seeking a steady income, as it offers fixed dividends that are typically paid regularly. This makes it appealing to income-oriented investors, such as retirees.
Less Volatility:
Compared to common stock, preferred stock tends to be less volatile. This is because its price is more sensitive to interest rates and its dividend payments are fixed, providing a level of stability.
Priority Over Common Stock:
In the event of financial trouble or liquidation, preferred stockholders have a better chance of recovering some of their investment than common stockholders. This can reduce the risk of losing the entire investment in a distressed company.
Potential for Price Appreciation (Convertible Preferred Stock):
If the preferred stock is convertible, there is potential for capital appreciation if the company’s stock price rises significantly. The option to convert into common stock can be particularly valuable in growing companies.
Disadvantages of Preferred Stock
Limited Capital Gains Potential:
While preferred stock can provide a steady income, it typically has limited potential for capital gains compared to common stock. The price appreciation of preferred stock tends to be more modest.
No Voting Rights:
Preferred stockholders generally do not have voting rights, so they are unable to influence company decisions, such as electing directors or approving major corporate actions.
Interest Rate Sensitivity:
Preferred stock is sensitive to changes in interest rates. When interest rates rise, the value of preferred stock typically falls because the fixed dividend becomes less attractive compared to newer securities with higher rates.
Callable Feature Risk:
If the preferred stock is callable, the issuing company can repurchase the shares at a predetermined price, often when interest rates decrease or market conditions improve. This may limit the potential for capital gains, as the company could call the stock and replace it with cheaper financing options.
Missed Dividends (Non-Cumulative Preferred Stock):
If a company chooses to skip a dividend payment, preferred shareholders may not receive compensation for the missed payment, particularly with non-cumulative preferred stock. This means the income stream from preferred stock can be unpredictable.
Types of Preferred Stock
Cumulative Preferred Stock:
This is the most common form of preferred stock. If a company misses a dividend payment, it must pay the missed dividend in the future before it can pay any dividends to common shareholders.
Non-Cumulative Preferred Stock:
With non-cumulative preferred stock, if the company skips a dividend, preferred shareholders lose that dividend, and there is no obligation for the company to make it up later.
Convertible Preferred Stock:
This type of preferred stock can be converted into common shares at a predetermined conversion ratio. It allows the holder to benefit from the potential upside if the company’s common stock price rises.
Participating Preferred Stock:
Holders of participating preferred stock have the right to receive additional dividends beyond the fixed rate if the company achieves certain financial milestones. They may also share in the company’s remaining assets after the preferred dividends have been paid out in the event of liquidation.
Redeemable Preferred Stock:
Redeemable preferred stock can be bought back (redeemed) by the issuing company at a predetermined price after a specified date. This feature allows the company to manage its capital structure.
Example of Preferred Stock in Action
Let’s say XYZ Corporation issues preferred stock with a 6% annual dividend on a $100 par value. The company issues 1,000 shares of preferred stock, so the total annual dividend obligation is:
Dividend per Share: $100 × 6% = $6
Total Dividend Payment: 1,000 shares × $6 = $6,000
This dividend must be paid to preferred shareholders before any dividends are paid to common shareholders. If the company misses a dividend payment (in the case of cumulative preferred stock), it must make up the missed payment in the future.
If the company is liquidated, the preferred stockholders would be entitled to receive their investment (the $100 per share) before common stockholders receive anything.
Conclusion
Preferred stock is a hybrid investment that combines the features of both debt and equity. It offers fixed dividends and priority over common stockholders in terms of dividends and liquidation, making it an attractive investment for income-seeking investors. However, it comes with trade-offs, such as limited capital gains potential and no voting rights. The choice between preferred and common stock depends on the investor’s income needs, risk tolerance, and investment goals.