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In the world of investments its important to know what you are getting into before you make a commitment from purchasing on your own or by an investment professional. Goal of this article is to teach you what is preferred stock, how is it used, what are some advantages and disadvantages plus risks involved.
What is Preferred Stock?
Preferred stock is a type of equity that allows investors to have a form of ownership from the issuing corporation or entity. Even though it’s a type of equity security it has some characteristics of debt securities such as bonds. Like debt securities, the rate of return on a preferred stock is fixed and does not fluctuate compared to common stock. The annual dividend of preferred stock represents a fixed rate of return. This is a key attraction for income-oriented investors.
The buyers of preferred stock are known as shareholders. It allows the investors to participate in the company’s prosperity. Investors can benefit from:
- receiving earnings from distributed profits (dividends)
- Priority over common stock in regards to bankruptcy
It does not allow preferred share holders to vote or have preemptive rights (opportunity to buy more shares to maintain your ownership percentage in the company).
Why would a company issue preferred stock?
A company or entity issues common stock to raise capital. When they raise capital it allows the issuer to receive the funds since the shares where sold in the primary market.
Keep in mind all corporations issue common stock, but not all corporations issue preferred stock.
How to identify preferred stock price to buy?
Preferred stock is usually identified by its annual dividend payment stated as a percentage of pare value (similar to a bond). For instance, a preferred stock with a par value of $100 that pays $6 in annual dividends is referred as 6% preferred ($6 dividend / $100 par).
Advantages of Preferred Stock
- Can receive income from dividends when declared by the Board of Directors (BOD)
- Preferred stock holders have limited liability
- Ex. If corporation becomes bankrupt, share holders cannot be forced to sell any personal assets to help pay the debts of the business
What are the risks of Preferred Stock?
- Purchasing Power Risk – the potential that inflation will exceed the fixed income resulting in purchasing less in the future.
- Interest rate sensitive – since similar to debt securities which are fixed-income, when interest rates rise, the value of preferred shares declines
- Decreased or no Dividend income – The possibliliity of dividend income to decrease or stop entirely if company performing bad. Deciding to pay a dividend is on the hands of the board of directors and is not guaranteed.
- Priority at dissolution – Though preffered stock is payed before common stock in the event of bankruptcy, they are still paid behind all creditors.
Why include preferred stock in portfolio?
- Fixed income from dividends
- Prior claim ahead of common stock
- Convertible preferred stock sacrifices income in exchange for potential appreciation
What are some types of Preferred stock?
There are several types of options when it comes to preferred stock which can adjust dividend rate and profit participating privileges. However, all maintain preference over common stock.
- Straight (noncumulative) – Has no special features beyond the stated dividend payment. If dividends are missed, shareholders don’t receive missed payment.
- Cumulative – It accrues payments due its shareholders in the event dividends are reduced or suspended. In other words, when board of directors declare dividends it will give back accrued dividends plus current dividends.
- Callable preferred – Corporations can issue callable preferred stock, it allows the company to buy back the stock from investors at a stated price after a specified date. It simply allows them to replace a higher fixed dividend obligation with a lower one. Once its called, dividend payments cease on the call date.
- Convertible preferred – It allows the owner of the shares to convert from preferred stock to fixed number shares of common stock.
- usually issued with a lower stated dividend rate than nonconvertible preferred.
- Adjustable-rate preferred – Dividends are tied to the rates of other interest rate benchmarks such as treasury bills and money market rates. Due to payments adjust to current interest rates, the price of the stock remains relatively stable.
- Participating Preferred – Offers its owners a share of corporate profits that remain after all dividends and interest due other securities paid. For instance, it can be described as XYZ 6% preferred participating 9% (pays holder extra 3% when declared by board of directors)
How to buy preferred stock?
Preferred stock is traded on exchanges such as NYSE, NASDQ, etc which allows price transparency. Before purchasing, an investor can review the credit rating from Moody’s or S&P 500 for each offering and take the rating into consideration plus any features that are mentioned above.
What are other options with less risk?
A great way to reduce risk is through diversification of their portfolio. One way of doing this is by using a mutual fund, which allows you to purchase a collection of stock from various company’s with just one offering.