To many people, preferred stock appears to be a cross between equity and debt securities. Although it is an equity security and represents ownership in the issuing corporation, it does not provide all of the privileges of ownership that are normally associated with common stock. Like a debt instrument, preferred stock is often (though not always) issued as a fixed income security with a stated dividend. Its price fluctuations tend to be affected more by changes in interest rates than by market forces. Unlike common stock, most preferred stock is issued as nonvoting stock. In short, preferred stock, like common stock, is an equity or share in the earnings and assets of the corporation.
Although preferred stock does not typically have the same growth potential as common stock (because its price is more likely to be affected by changes in interest rates than by changes in company profits), the owners of preferred stock generally have an advantage over common stockholders in two ways:
1. When dividends are declared by the board of directors, owners of preferred stock receive their dividends (plus any dividends in arrears) first; and
2. If a corporation goes bankrupt after paying off creditors, preferred stockholders have a prior claim on the remaining assets. Common stockholders’ claims are typically the last ones paid.
Dividend preference over common stock: After the interest and all the operating expenses and bond interest have been paid, the preferred stockholder has priority over the common stockholder for dividends. Therefore, dividends (once they have been declared by the board of directors) must be paid to preferred stockholders before they can be paid to common stockholders. This gives holders of preferred stock a higher probability of receiving regular income than the holders of common stocks.
The preferred stockholder has no claim against the company for dividends unless declared by the board of directors. There are no rights of a creditor or bondholder and preferred stockholders cannot throw the company into receivership for not paying preferred dividends.
Some preferred stocks have cumulative features. These features are described in the charter of the corporation. They usually provide that, if the full dividend is not paid each quarter, it accrues or accumulates to the benefit of the stockholders. Companies might have large accumulations of back dividends, yet be in no danger of insolvency. However, a company cannot pay dividends on the common stock until all the dividends accumulations are paid to the preferred stockholders.
Almost all preferred stocks are callable at the option of the corporation at a specified price. The charter states the terms under which a corporation may call its stocks. These terms include the call price, the number of days notice required and the place of payment.
Stated (fixed) rate of return: To most owners of preferred stock, the stock’s most attractive feature is its fixed dividend (although preferred stocks with variable dividends exist, they are not common). If the stock has been assigned a par value (a value normally much higher than that assigned to the corporation’s common stock), it will state the annual dividend payments in terms of percentage of par value. A preferred stock with a par value of $100 that pays $6 in annual dividends would be known as a 6 percent preferred. No-par value preferred stock has a dividend stated in a dollar amount. A $6 no-par preferred would pay a $6 annual dividend.
Prior claim over assets at dissolution: Holders of preferred stock can make a claim against the assets of the corporation (in the event of its liquidation) before common stockholders can.
Limited ownership privileges: Preferred stocks usually do not carry either voting rights or preemptive rights. There are exceptions, however, including those times when a company is in financial difficulty and the occasional issue of preferred stock with full or limited voting rights.
Unlike corporate bonds (or other debt securities), preferred stock has no preset date at which it matures or is scheduled for redemption by the corporation. Once a company has sold a preferred stock, the money received is in sense permanent money. The corporation never has to pay it back.
Finally, for those who want to take less risk, yet have some of the upside associated with common stocks, preferred stock can be an excellent way to go. Taking inventory of your investing attitude, objective and risk posture is always the first place to start. And remember, no matter what you invest in, there is always risk.
Quote of the Week: “Leadership: the art of getting someone else to do something you want done because he wants to do it.”—Dwight D. Eisenhower
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.