Preferred Stock

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DEFINITION of 'Preferred Stock'

A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, and the shares usually do not carry voting rights.

Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price. The details of each preferred stock depend on the issue. 

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BREAKING DOWN 'Preferred Stock'

Preferred shareholders have priority over common stockholders when it comes to dividends, which generally yield more than common stock and can be paid monthly or quarterly. These dividends can be fixed or set in terms of a benchmark interest rate like the LIBOR​. Adjustable-rate shares specify certain factors that influence the dividend yield, and participating shares can pay additional dividends that are reckoned in terms of common stock dividends or the company's profits.

Companies in Distress

If a company is struggling and has to suspend its dividend, preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders. Shares that have this arrangement are known as cumulative. If a company has multiple simultaneous issues of preferred stock, these may in turn be ranked in terms of priority: the highest ranking is called prior, followed by first preference, second preference, etc.

Preferred shareholders have prior claim on a company's assets if it is liquidated, though they remain subordinate to bondholders. Preferred shares are equity, but in many ways they are hybrid assets that lie between stock and bonds. They offer more predicable income than common stock and are rated by the major credit rating agencies. Unlike with bondholders, failing to pay a dividend to preferred shareholders does not mean a company is in default. Because preferred shareholders do not enjoy the same guarantees as creditors, the ratings on preferred shares are generally lower than the same issuer's bonds, with the yields being accordingly higher.

Voting Rights, Calling and Convertability

Preferred shares usually do not carry voting rights, although under some agreements these rights may revert to shareholders that have not received their dividend. Preferred shares have less potential to appreciate in price than common stock, and they usually trade within a few dollars of their issue price, most commonly $25. Whether they trade at a discount or premium to the issue price depends on the company's credit-worthiness and the specifics of the issue: for example, whether the shares are cumulative, their priority relative to other issues, and whether they are callable.

If shares are callable, the issuer can purchase them back at par value after a set date. If interest rates fall, for example, and the dividend yield does not have to be as high to be attractive, the company may call its shares and issue another series with a lower yield. Shares can continue to trade past their call date if the company does not exercise this option.

Some preferred stock is convertible, meaning it can be exchanged for a given number of common shares under certain circumstances. The board of directors might vote to convert the stock, the investor might have the option to convert, or the stock might have a specified date at which it automatically converts. Whether this is advantageous to the investor depends on the market price of the common stock.

Typical Buyers of Preferred Stock

Preferred stock comes in a wide variety of forms. The features described above are only the more common examples, and these are frequently combined in a number of ways. A company can issue preferred shares under almost any set of terms, assuming they don't fall foul of laws or regulations. Most preferred issues have no maturity dates or very distant ones.

Due to certain tax advantages that institutions enjoy with preferred shares but individual investors do not, these are the most common buyers. Because these institutions buy in bulk, preferred issues are a relatively simple way to raise large amounts of capital. Private or pre-public companies issue preferreds for this reason.

Preferred stock issuers tend to group near the upper and lower limits of the credit-worthiness spectrum. Some issue preferred shares because regulations prohibit them from taking on any more debt, or because they risk being downgraded. While preferred stock is technically equity, it is similar in many ways to a bond issue; some forms, known as trust preferred stock, can act as debt from a tax perspective and common stock on the balance sheet. On the other hand, several established names like General Electric, Bank of America and Georgia Power issue preferred stock to finance projects. 

For more on this interesting hybrid security, read A Primer on Preferred Stocks and Valuation of Preferred Stocks.

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