Preferred Stock Basics: The Hybrid Between Bonds and Equity
Learn how preferred stock works, the differences between preferred and common shares, and when preferred stock fits an income-focused portfolio.
What is preferred stock?
Preferred stock sits between bonds and common equity in a company's capital structure. Holders receive a fixed dividend before common shareholders get anything, but they typically lack voting rights. If the company is liquidated, preferred claims are paid after bondholders but ahead of common stockholders.
Key features of preferred shares
- Fixed dividend rate, usually stated as a percentage of par value
- Priority over common stock for dividends and liquidation proceeds
- Cumulative vs non-cumulative: cumulative preferred accrues missed dividends
- Callable provisions allow the issuer to redeem shares after a set date
- Convertible preferred can be exchanged for common shares at a preset ratio
Because preferred dividends are fixed, preferred share prices move inversely with interest rates, much like bonds. Rising rates tend to push preferred prices down.
When preferred stock makes sense
Income investors sometimes favor preferred stock for its higher yield relative to common dividends. However, preferred holders sacrifice upside participation. Evaluate the issuer's credit quality, call schedule, and whether dividends are cumulative before committing capital.
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FAQs
How is preferred stock taxed compared to common stock?▼
Qualified preferred dividends are typically taxed at the lower capital gains rate, similar to qualified common dividends. However, some preferred issues pay interest rather than dividends, which is taxed as ordinary income.
Can preferred stock lose value?▼
Yes. Preferred prices fall when interest rates rise or when the issuer's creditworthiness deteriorates. In bankruptcy, preferred holders can lose their entire investment if assets are insufficient after paying bondholders.
What is the difference between cumulative and non-cumulative preferred?▼
Cumulative preferred accrues any missed dividends, and the company must pay them before resuming common dividends. Non-cumulative preferred has no such obligation, making missed payments permanently lost to shareholders.
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Intrinsic Investor is for education and research only. Not financial advice.