What Is Preferred Stock?

What Is Preferred Stock?

Publicly traded companies issue common stock to raise capital. They may also offer bonds and preferred stock. The latter provides the stability and income you'd expect from a bond, plus the equity you'd get from a common stock. Preferred stocks tend to pay regular fixed dividends, and they're considered safer investments than common stock. However, growth potential may be limited. Here's a closer look at how preferred stock compares to common stock and bonds.

Preferred Stocks vs. Common Stocks

When you purchase shares of common stock, you receive equity—or an ownership stake—in the company. The same goes for preferred stock, but there are some key differences to consider.

• Common stock shareholders have voting rights. If you own shares of common stock, you have the right to vote at shareholder meetings. That enables you to elect directors and make your voice heard if you choose to do so.
• Dividends are structured differently. Some companies issue dividend payments to share some of their profits with shareholders. With preferred stock, you can expect fixed dividend payments—and the yield is usually higher when compared to common stock dividends.
• In the event of bankruptcy, preferred stock is higher on the totem pole. If a company declares bankruptcy or announces a liquidity event, bondholders will be the first to be paid. Preferred shareholders are next. Common stock shareholders will only be paid out if there are funds remaining.
• Growth potential is usually limited with preferred stock. If a company is successful, its common stock price could climb by leaps and bounds. Investors could realize substantial gains if they sell their shares for more than they paid. But preferred stocks may be callable. That means the issuer could force you to cash out your outstanding shares—cutting you off from future appreciation.

Preferred Stocks vs. Bonds

Both preferred stocks and bonds can provide steady streams of reliable income. Risk is low, and bonds can also be callable. What's more, bond prices and preferred stock values are both linked to interest rates. Values typically decrease as interest rates rise, and vice versa. That said, here are some ways that preferred stock is different from bonds.

• Bonds don't provide equity. Purchasing a corporate bond is like extending a loan. The company is obligated to repay you, with interest. That makes you a debt holder and doesn't buy you an ownership position.
• Bonds are safer than preferred stocks. Again, if a company faces a liquidity event—including bankruptcy—bondholder payments will take priority.
• Preferred stock typically offers better returns. Dividend payments for preferred stock may be higher than corporate bond yields.

Pros and Cons of Preferred Stocks

Choosing to invest in preferred stocks has its benefits and its drawbacks.

Pros

• Preferred stocks give investors an ownership position in publicly traded companies.
• Preferred stocks provide fixed dividend payments on a regular timetable.
• Risk is lower than investing in common stock.

Cons

• Preferred stocks can be callable. If the company calls back a stock early, you could miss out on potential gains.
• They're affected by changing interest rates. In a rising-rates environment, preferred stock values tend to decrease.
• With certain types of preferred stock, companies can skip dividend payments with no obligation to make them up to shareholders.

Should I Buy Preferred Stocks?

Whether preferred stock is right for you will depend on your investment goals. If you're looking to generate regular income from your portfolio, dividends are worth exploring—and dividend payments are typically higher with preferred stock than common stock. Meanwhile, you'll have an equity position in the company.

But returns on preferred stock are generally less robust when compared to common stock. You'll want to consider your long-term financial goals when choosing your asset allocation. One alternative may be to add dividend-paying common stocks to your portfolio.

How to Buy Preferred Stocks

You can purchase preferred stocks through a brokerage that offers them. You'll just need to open and fund a brokerage account. If finding and researching individual stocks feels daunting, a preferred stock fund is an option. There are exchange-traded funds (ETFs) that focus on preferred securities. They can help diversify your portfolio and mitigate overall investment risk. For example, some ETFs hold preferred stocks and high-yield corporate bonds. ETFs are also more hands-off when compared to individual stock investing.

The Bottom Line

Preferred stock is a unique type of asset that functions like a stock and a bond rolled into one. These stocks provide regular dividend payments, and risk is generally on the lower side, but potential returns may trail behind common stock. Like any investment, there are pros and cons to consider.

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