Unlocking the Secrets of Preferred Stock: What Investors Need to Know Today

When companies seek to raise capital, they often issue stocks available to any investor willing to buy. Typically, companies don't discriminate among investors, but sometimes they aim to attract those who prefer steady, scheduled income.

To cater to such investors, corporations might issue bonds, which have distinct advantages and drawbacks. But if a company wants to provide equity stakes while guaranteeing regular payments without issuing bonds, preferred stock offers a compelling solution. Preferred stock combines features of bonds and common stock, providing fixed dividends but limited control.

Let's delve into the key characteristics of preferred stock and why it's a unique investment option.

Key Insights

• Preferred stock blends bond-like fixed dividends with equity ownership but typically excludes voting rights.
• Most leading companies have phased out preferred stock issuance; however, large banks such as Wells Fargo and Bank of America continue to offer them.
• In bankruptcy scenarios, preferred shareholders have priority over common shareholders but rank behind bondholders.
• Preferred shares usually trade near $25 per share and often feature dividend rates that can be fixed or fluctuate based on market benchmarks.

Preferred Stock: A Rare Breed

The distinction between preferred and common stock is subtle but significant. Preferred shareholders receive dividends by design, whereas common shareholders may or may not receive dividends depending on company performance.

Notably, blue-chip companies that pay dividends on common stock generally do not issue preferred stock. This class of shares is becoming increasingly rare, with tech giants like Apple, Microsoft, and energy leaders like ExxonMobil abstaining from issuing preferred shares.

In the United States, preferred stock issuance is predominantly seen among major financial institutions such as Wells Fargo, Bank of America, Citigroup, and JPMorgan Chase. This trend traces back to the financial crisis of 2008-09, where preferred stock served as a valuable capital buffer for banks.

No Voting Rights: A Trade-Off

Preferred stockholders enjoy fixed dividends but typically sacrifice voting privileges. Unlike common shareholders who elect the board of directors, preferred shareholders do not participate in corporate governance decisions, despite the “preferred” label.

Priority in Bankruptcy

If a company faces bankruptcy and liquidation, bondholders are paid first as creditors. Next in line are preferred shareholders, who receive payments before common shareholders. This hierarchy underscores the “preferred” status of these shares.

Preferred shares may also be callable at the company's discretion, allowing the issuer to repurchase them at a predetermined price. Additionally, many preferred shares offer conversion options to common stock, trading dividend certainty for potential capital gains.

Important Note

Some preferred stocks have a cumulative feature, requiring companies to pay any missed dividends to preferred shareholders before common dividends can resume.

How to Identify Preferred Stock

Preferred stocks are listed differently from common shares, often by series designations. For example, Allstate’s preferred shares are categorized as Series H, I, and J, each with distinct dividend yields.

• Series H: 5.10%
• Series I: 4.75%
• Series J: 7.375%

Goldman Sachs, for instance, has multiple preferred stock series, each with unique dividend rates.

Preferred Stock: Bond-Like Behavior

Preferred shares generally trade around a $25 par value, reflecting their bond-like nature. This stable pricing signals market perception of preferred stock as a fixed-income-like instrument.

Some preferred stocks feature floating dividend rates tied to benchmarks such as the Secured Overnight Financing Rate (SOFR), adjusting payouts with market conditions.

Understanding Preferred Stock

Preferred stock is a hybrid security offering fixed dividends similar to bonds but without voting rights. In bankruptcy, preferred shareholders have payment priority over common shareholders but rank below debt holders. While less common today, preferred stock remains a key capital tool for large banks.

Example: 5% Preferred Stock with $100 Par Value

A 5% preferred stock with a $100 par value pays $5 annually in dividends, typically in cash. The dividend rate is fixed, but the yield may vary with market price fluctuations.

Drawbacks of Preferred Stock

Despite fixed dividends, payments are not guaranteed if the company faces financial difficulties. Cumulative preferred stocks require missed dividends to be paid before common dividends resume; non-cumulative stocks lack this protection.

Preferred shareholders usually lack voting rights, limiting influence over corporate decisions. Additionally, preferred stock prices tend to hover near par value, offering limited capital appreciation compared to common stocks.

Conclusion

Preferred stocks offer investors a blend of income stability and reduced risk compared to common shares, making them suitable for those seeking moderate risk exposure. Institutional investors predominantly hold preferred shares due to their bond-like characteristics.

For individual investors, preferred stock investments are typically considered after building a diversified common stock portfolio. Those interested might explore preferred stock exchange-traded funds (ETFs) as a convenient way to access this asset class.

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