What is Preferred Stock?
Preferred stock, which also known as preference shares or preferred shares, is a type of stock that represents ownership in a company. Preferred stock is considered a hybrid security because it comprises elements of both stocks and bonds. It offers a fixed-income component through its fixed dividend payments; it also carries the potential for capital appreciation if convertible. However, preferred stock is different from common stock in several ways because of following characteristics: –
- Priority of dividends: Preferred stockholders have a higher claim on the company’s earnings and assets compared to common stockholders. They receive their dividends before dividends are paid to common stockholders. The dividend payments for preferred stock are usually fixed, predetermined, and expressed as a percentage of the stock’s par value.
- Fixed dividend rate: Preferred stock typically carries a fixed dividend rate, which means the dividend payments are a specified amount or a percentage of the stock’s face value. The dividend rate is determined when the stock is issued and remains relatively constant over time.
- Limited voting rights: Unlike common stockholders, preferred stockholders often have limited or no voting rights. In some cases, preferred stockholders may have voting rights only on matters that directly affect their rights, such as changes to the terms of the preferred stock or the company’s ability to pay dividends.
- Priority in liquidation: If a company goes bankrupt or is liquidated, preferred stockholders have a higher claim on the company’s assets compared to common stockholders. They are typically paid their invested capital and any accrued dividends before common stockholders receive anything.
- Convertibility: Some preferred stocks are convertible, which means they can be exchanged for a predetermined number of common shares. This feature allows investors to benefit from potential future growth in the company’s stock price.
What are The Types of Preferred Stock?
There are various types of preferred stock that differ based on specific features and characteristics. Followings are some common types:
- Cumulative Preferred Stock: This type of preferred stock accumulates any unpaid dividends. In case a company fails to pay dividends in any period, the missed dividends are carried forward and must be paid in the future before any dividends can be paid to common stockholders.
- Non-Cumulative Preferred Stock: Non-cumulative preferred stock does not accumulate unpaid dividends. If the company fails to pay dividends in a particular period, the missed dividends are lost and cannot be claimed by the stockholders in the future.
- Callable Preferred Stock: Callable preferred stock comprises a provision that allows the issuer to redeem the shares at a predetermined call price after a specified date. The call price is often set at a premium to the stock’s par value. This feature provides the issuer with the flexibility to retire the preferred stock if interest rates decline or if the company wants to adjust its capital structure.
- Convertible Preferred Stock: Convertible preferred stock grants the holder the right to convert their preferred shares into a predetermined number of common shares. This feature allows preferred stockholders to potentially benefit from capital appreciation if the company’s common stock price rises.
- Adjustable-Rate Preferred Stock: Adjustable-rate preferred stock, also known as floating-rate preferred stock, carries a dividend rate that is tied to a benchmark interest rate, such as the U.S. Treasury bill rate or the LIBOR. The dividend payments on these stocks change periodically based on the fluctuations in the benchmark interest rate.
- Participating Preferred Stock: Participating preferred stock allows the stockholders to receive additional dividends beyond the fixed rate if the company achieves certain financial milestones or if there is a surplus of profits available for distribution to shareholders. This feature provides preferred stockholders with the opportunity to share in the company’s success alongside common stockholders.
- Perpetual Preferred Stock: Perpetual preferred stock has no maturity date, meaning it has an indefinite term. The company is not obligated to redeem or repay the shares at a specific time. As long as the company remains solvent, it continues to pay dividends on perpetual preferred stock.
Advantages and Disadvantages of Preferred Stock:
Advantages:
- Dividend Priority: As discussed above preferred stockholders have a higher priority when it comes to receiving dividends compared to common stockholders. They receive dividends before common stockholders and enjoy a more predictable income stream.
- Fixed Dividend: Preferred stock normally offers a fixed dividend rate, providing investors with a stable income source. This fixed income feature can be attractive to income-oriented investors seeking regular cash flow.
- Preference in Liquidation: In the event of a company’s liquidation or bankruptcy, preferred stockholders have a higher claim on the company’s assets compared to common stockholders. They are entitled to receive their invested capital and any unpaid dividends before common stockholders receive anything.
- Convertibility: Some preferred stocks are convertible into common shares. This feature allows investors to benefit from potential capital appreciation if the company’s common stock price rises.
- Lower Volatility: Preferred stock tends to have lower price volatility compared to common stock. This can be advantageous for investors who prefer a more stable investment with less price fluctuation.
Disadvantages:
- Limited Capital Appreciation: Preferred stock generally offers limited potential for capital appreciation. The focus is primarily on receiving regular dividend payments rather than experiencing significant share price growth.
- Lack of Voting Rights: Preferred stockholders typically have limited or no voting rights. This means they have limited influence or control over corporate decisions compared to common stockholders.
- Interest Rate Sensitivity: Many preferred stocks have fixed dividend rates that are sensitive to changes in interest rates. If interest rates rise, the relative attractiveness of preferred stock may decline, potentially affecting the market value of these securities.
- Subordination to Debt Holders: In the event of financial distress or bankruptcy, preferred stockholders are still subordinate to debt holders. This means that debt holders have higher priority in receiving payments from the company’s assets.
- Potential Call Risk: Callable preferred stock carries the risk of being called by the issuer. If the company exercises its right to redeem the shares, investors may face reinvestment risk if they are unable to find similar investment opportunities with comparable returns.
Who are The Buyers of Preferred Stocks?
Buyers of preferred stocks can have variety of investors with different investment goals and strategies. Here are some typical buyers who take interest in preferred stocks:
- Individual Investors: Individual investors, including retail investors, may purchase preferred stocks as part of their investment portfolio. They might be attracted to the stable income provided by preferred stock dividends or seek the potential for capital appreciation through convertible preferred stocks.
- Institutional Investors: Institutional investors such as mutual funds, pension funds, insurance companies, and hedge funds often invest in preferred stocks. These institutions have significant capital to allocate and may include preferred stocks in their portfolios to achieve specific investment objectives, such as income generation or risk diversification.
- Income-Oriented Investors: Investors seeking regular income streams may be drawn to preferred stocks due to their fixed dividend payments. These investors often prioritize stable and predictable cash flow over potential capital appreciation.
- Conservative Investors: Preferred stocks are often considered less risky than common stocks due to their higher priority in dividend payments and liquidation preferences. Conservative investors who are more risk-averse may choose preferred stocks as a way to balance their portfolios and potentially reduce overall investment risk.
- Financial Institutions: Banks and other financial institutions may purchase preferred stocks as part of their investment strategies. These institutions often have specific regulatory requirements and investment guidelines that make preferred stocks an attractive asset class for them.
- High-Net-Worth Individuals: Wealthy individuals with substantial investable assets may also include preferred stocks in their portfolios. They may have specific investment advisors or wealth management teams who recommend preferred stocks as part of their overall investment strategy.
10 Examples of Preferred Stocks:
- Berkshire Hathaway Inc. (Ticker: BRK.A, BRK.B) – Berkshire Hathaway, the multinational conglomerate led by Warren Buffett, has preferred stocks issued under its name. These preferred stocks are highly sought after due to the strong financial position and reputation of the company.
- General Electric Company (Ticker: GE) – General Electric has issued several series of preferred stocks over the years. These preferred stocks often offer attractive dividend rates and are considered by income-oriented investors.
- JPMorgan Chase & Co. (Ticker: JPM) – JPMorgan Chase, one of the largest banks in the United States, has issued preferred stocks. These stocks are typically popular among institutional investors seeking stable income investments.
- Royal Dutch Shell plc (Ticker: RDSA, RDSB) – Royal Dutch Shell, one of the largest oil and gas companies globally, has issued preferred stocks that are traded on various stock exchanges. These preferred stocks often offer attractive dividend rates and are of interest to income-oriented investors.
- Nestle S.A. (Ticker: NESN) – Nestle, a multinational food and beverage company based in Switzerland, has issued preferred stocks that are listed on European stock exchanges. These preferred stocks may provide stable dividend income for investors.
- Banco Santander, S.A. (Ticker: SAN) – Santander, a Spanish multinational bank, has issued preferred stocks that are listed on various stock exchanges. These preferred stocks are often sought after by income-focused investors seeking exposure to the financial sector.
- Toyota Motor Corporation (Ticker: TM) – Toyota, one of the world’s largest automobile manufacturers, has issued preferred stocks that trade on global stock exchanges. These preferred stocks may offer stable dividend payments to investors.
- Commonwealth Bank of Australia (Ticker: CBA) – Commonwealth Bank, one of Australia’s largest banks, has issued preferred stocks that are traded on the Australian Securities Exchange (ASX). These preferred stocks may be of interest to investors looking for income-generating opportunities in the Australian market.
- Samsung Electronics Co., Ltd. (Ticker: 005930.KS) – Samsung, a South Korean multinational conglomerate, has issued preferred stocks listed on the Korean stock exchange. These preferred stocks may be attractive to investors seeking exposure to the technology and consumer electronics industry.
10. The Coca-Cola Company (Ticker: KO) – Coca-Cola is known for issuing preferred stocks with steady dividend payments. These preferred stocks are sometimes appealing to investors looking for reliable income streams.
The Bottom Line:
Preferred stock can be an attractive investment option for certain investors due to its unique features. Investors who are interested in generating cash flow from their equity holdings may be better suited holding preferred equity or stock. This kind of equity investment represents ownership of a company and results in prioritized treatment for dividend distributions. Though there are certain sacrifices for this right, because preferred stock is simply a different instrument for owning part of a business.
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