Preferred stock is a unique class of ownership that offers investors a higher claim on assets and earnings compared to common stock. It combines characteristics of both bonds and common stock, making it an attractive investment option for certain investors. In this article, we will delve into the fundamentals of preferred stock, its distinguishing features, and the various types of preferred stock available in the market.

Understanding Preferred Stock

Preferred stock represents an ownership stake in a company and grants shareholders the right to claim income from the company's operations. One key advantage of preferred stock is its higher claim on distributions, such as dividends, compared to common stock. Preferred stockholders are prioritized over common stockholders when it comes to receiving dividends, which are typically higher and can be paid on a monthly or quarterly basis.

Dividends on preferred stock can be fixed or based on a benchmark interest rate like the London InterBank Offered Rate (LIBOR). The dividend rates are often expressed as a percentage in the issuing description. Additionally, some types of preferred stock, known as adjustable-rate shares, have dividends influenced by specific factors. Participating shares may also pay additional dividends based on the company's profits or common stock dividends, providing potential upside to preferred stockholders.

One notable characteristic of preferred stock is its limited voting rights, typically lacking the voting power that common stockholders possess. This feature distinguishes preferred stock from common stock, appealing to investors seeking stability in potential future cash flows.

Types of Preferred Stock 

There are different types of preferred stock, each with its unique features and priorities. Let's explore some of the most common types:

1. Prior Preferred Stock: This type of preferred stock holds precedence over regular preferred stock in terms of prioritization for creditors or dividend awards. If a company can only afford to pay dividends to one tier of shares, it must first allocate the payment to prior preferred stockholders.

2. Preference Preferred Stock: Falling behind prior preferred stock but ranking higher than other issuances, preference preferred stock is the next tier of stock in terms of prioritization. Multiple tiers of preference preferred stock may be assigned specific ranks, such as most senior or second senior.

3. Perpetual Preferred Stock: While some preferred stocks have a fixed end date, perpetual preferred stock does not. Investors in perpetual preferred stock do not receive a return of their initial capital contribution; instead, they must sell their shares on the market if they wish to redeem them.

4. Convertible Preferred Stock: This type of preferred stock allows shareholders to convert their shares into common stock at their discretion. The conversion can occur regardless of the prevailing share prices. Once the exchange is made, the investor relinquishes the right to convert the common shares back into preferred shares. The conversion ratio, specifying how many common shares can be obtained per preferred share, is predefined.

5. Cumulative Preferred Stock: In case a company issues dividends but fails to pay them out, cumulative preferred stock ensures that the unpaid dividends accumulate and must be paid in the future before lower-tier shares receive dividends. Preferred stockholders hold precedence over common stockholders in receiving dividend payments.

6. Noncumulative Preferred Stock: Unlike cumulative preferred stock, noncumulative preferred stock does not accumulate unpaid dividends. Dividends are treated on a year-to-year basis, and missed dividends in prior periods do not carry over into subsequent periods. This type of stock is often found in the banking sector due to international regulations governing the classification of capital.

7. Participating Preferred Stock: Even in years when a company cannot afford to issue dividends, participating preferred stockholders may still receive a dividend based on specific company achievements, such as total sales or earnings. These additional dividends are in addition to any regular dividends the company may pay, subject to the availability of sufficient finances.

Summary

Preferred stock are dividend-paying equity shares issued by corporations, which pays a dividend with a higher priority than common stock, but lacks the voting rights that come with common stock.

Preferred stock is very similar to a bond, because it will often be issued to raise capital for projects, and dividends (or interest) are expected to be paid regularly by the issuing company, but it still experiences the appreciation (and depreciation) of equity shares.

Unlike common stock, preferred stock has no voting rights. Preferred stock may or may not have a maturity date. Regular preferred stock might experience periods without dividend payments, but Cumulative Preferred stock would be paid-up for the dividends the company missed payments on, if dividend payments started again.

Dividend rates on preferred stocks are usually stated in the contract, so dividend payments over and above that amount can go to holders of common stock or elsewhere; in other words, preferred stock does not have as much upside potential as common stock, but it may capture more of it if it is "participating preferred" stock.

There are also callable preferred and convertible preferred shares. Preferred stocks are traded on exchanges and are generally issued at $25 per share. Bonds are senior to preferred stock in the event of bankruptcy.

There are hybrid securities which blend debt and equity, mostly for tax purposes. If the preferred stock is packaged as MIPS, QUIPS, and TOPrS, the dividend payments are deductible by the issuer.

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