How does a preferred stock work?
Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par, usually at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares falls.
Preferred stocks promise a steady stream of income through dividend payments. A preferred stock's dividend payments are usually higher than bond payments and they're set at a fixed rate, usually somewhere between 5–7%. They're also paid out before common stock dividends, but after bondholders receive their payments.
What Is an Example of a Preferred Stock? Consider a company is issuing a 7% preferred stock at a $1,000 par value. In turn, the investor would receive a $70 annual dividend, or $17.50 quarterly. Typically, this preferred stock will trade around its par value, behaving more similarly to a bond.
That means it might be harder to buy or sell your preferred stocks at the prices you seek. To sum it up: Preferred stocks are usually less risky than common dividend stocks, and carry higher yields, but lack the opportunity for price appreciation as the issuing company grows. They also go without voting rights.
Why Investors Demand Preference Shares. Most shareholders are attracted to preferred stocks because they offer more consistent dividends than common shares and higher payments than bonds.
The dividends for preferred stocks are by definition determined in advance and paid out before any dividend for the company's common stock is determined. The dividend may be a set percentage or may be tied to a particular benchmark interest rate. The dividend is generally paid on a quarterly or annual basis.
Similar to a bond, a preferred stock regularly pays income. The difference is that preferred stocks pay income in the form of a dividend, whereas bonds pay interest and the return of principal at maturity. Preferred stock is sensitive to fluctuations in interest rates.
Common stock investments have a potentially larger reward, but also come with more risk because they're exposed to the market. Preferred stock investments are a safer investment with fixed-income dividends, but investors may miss out on a share's appreciation they would get with common stock.
Overall, preferred shares are an attractive option for investors seeking steadier income with a slightly higher risk profile than bonds but lower risk than common stock. They can be thought of as a hybrid security with characteristics of both debt and equity instruments.
Preferred dividends are paid on the par value (face value) of stock each quarter. Unlike the share value, the par value of stock does not fluctuate, and your dividend rate is set out in your stock's prospectus.
Can you lose dividends with preferred stock?
Preferred stock dividends have priority over common stock dividends. But if a company misses dividend payments on preferred stock, investors lose out on that income (unless they own cumulative preferred stock).
Investors that are looking for income and are willing to take some risk for higher yields could consider preferreds, but investors with more-conservative to moderate risk tolerances might want to consider investment-grade corporate bonds instead.
The market prices of preferred stocks do tend to act more like bond prices than common stocks, especially if the preferred stock has a set maturity date. Preferred stocks rise in price when interest rates fall and fall in price when interest rates rise.
- High-yield savings accounts.
- Money market funds.
- Short-term certificates of deposit.
- Series I savings bonds.
- Treasury bills, notes, bonds and TIPS.
- Corporate bonds.
- Dividend-paying stocks.
- Preferred stocks.
Government bonds (aka "Treasurys") are generally considered the safest investments because they're backed by the full faith and credit of the U.S. government. Other types of bonds include corporate bonds and municipal bonds (earnings on the latter are exempt from federal taxes).
APPLE INC.
The Company is authorized to issue Common Stock and Preferred Stock.
General Risks
A big risk of owning preferred stocks is that shares are often sensitive to changes in interest rates. Because preferred stocks often pay dividends at average fixed rates in the 5% to 6% range, share prices typically fall as prevailing interest rates increase.
In virtually all cases, what happens is that the liquidation preference amount (generally equal to the original purchase price paid at the IPO), plus any accrued and unpaid dividends, is returned to the holder of the security. Note that the amount returned has NOTHING to do with the market price prior to maturity date.
Preferred securities generally have long maturity dates—like 30 years or longer—or no maturity date at all, meaning they are perpetual in nature. However, most preferreds have a stated "call date" that the issuer may choose to redeem them, usually at the par value.
Issued primarily by investment grade companies, preferreds offer 6-8% yields, considerably greater than investment-grade corporate bonds. Their dividend reset structures can also provide advantages in sustained high-rate environments, a benefit not found in typical fixed income investments.
Is preferred stock taxed?
Generally, preferred stock dividends, even though having characteristics of bonds, are taxed at the lower capital gains tax rate than at normal income levels as long as they qualify. However, preferred stock have complex treatment under the tax code and can be treated in different ways than common stock.
Preferred securities count toward regulatory capital requirements so banks issue preferreds to help them maintain their required capital ratio. Preferreds can also offer issuers structural benefits, lower capital costs and improved agency ratings.
Investors like preferred stock because this type of stock often pays a higher yield than the company's bonds. So if preferred stocks pay a higher dividend yield, why wouldn't investors always buy them instead of bonds? The short answer is that preferred stock is riskier than bonds.
Your VCs will get preferred stock; unlike your common stock, it will come with special privileges. Liquidation preferences reduce investor risk; understand what they'll mean in different scenarios. Don't come to the negotiating table without consulting with an experienced advisor first.
A preferred stock pays stockholders set dividend payments on a regular schedule, but does not have voting rights or as much potential for capital appreciation as common stock. Investors tend to buy shares of preferred stock for their consistent income and lower financial risk if a company faces losses.
