What is Preferred Stock? Understanding Types & Benefits

What is Preferred Stock?

Preferred stock is a unique type of equity that blends characteristics of both common stock and bonds. As a hybrid security, preferred stock offers a fixed dividend, much like a bond, but also represents ownership in the company, similar to common stock. However, what sets preferred stock apart is its "preferred" status—holders of preferred shares enjoy priority over common shareholders when it comes to receiving dividends and in the event of a company's liquidation. For income-focused investors, preferred stock is often an attractive option due to its higher and more consistent dividend yields compared to common stock.

Preferred Stock vs Common Stock: Key Differences

While both preferred and common stock are forms of equity, they serve different purposes and appeal to different types of investors. See below for a summary of key differences between common stock and preferred stock:

• Dividend Payments: Preferred stockholders are entitled to fixed dividends, paid before any dividends are distributed to common shareholders. In contrast, common stockholders receive dividends that are variable and depend on the company's profitability.
• Voting Rights: Common stockholders usually have voting rights in corporate matters, giving them a say in company decisions. Preferred shareholders, on the other hand, generally do not have voting privileges.
• Risk: Preferred stock carries less risk than common stock, primarily because of its fixed dividend payments and priority claim on assets in the event of bankruptcy. However, preferred stock does not offer the same growth potential as common stock, which can appreciate significantly if the company performs well.

For investors, preferred stock is typically seen as a safer, more stable income stream, while common stock is ideal for those seeking growth opportunities with a higher risk tolerance.

Types of Preferred Stock

There are several variations of preferred stock, each with its own characteristics and benefits:

• Cumulative Preferred Stock: If a company skips dividend payments, cumulative preferred shareholders are entitled to receive those missed dividends before common shareholders can be paid.
• Non-Cumulative Preferred Stock: These shares do not accumulate unpaid dividends. If the company misses a dividend payment, the shareholder has no claim on those missed payments in the future.
• Convertible Preferred Stock: Holders of these shares have the option to convert their preferred shares into a specified number of common shares, offering the potential for capital appreciation.
• Callable Preferred Stock: These shares can be "called" or redeemed by the issuing company at a predetermined price after a specified date.

In addition to these types, there is also the broader category of preferred securities, which includes hybrid instruments like convertible preferreds that combine features of both equity and debt.

Cumulative vs Non-Cumulative Preferred Stock

Cumulative preferred stock provides a critical safety net for income-focused investors. This feature ensures that if a company is unable to pay a dividend, those unpaid dividends accumulate and must be paid out before any dividends are distributed to common shareholders. For investors seeking steady and reliable income, this "cumulative" feature offers additional protection, making these shares more attractive, particularly during times of financial uncertainty or market downturns.

Example: General Electric’s Cumulative Preferred Stock

A well-known example of cumulative preferred stock comes from General Electric (GE), a major industrial conglomerate. During the 2008 financial crisis, many companies—including GE—faced financial challenges that forced them to suspend dividend payments on their common stock. However, GE’s cumulative preferred stockholders were still entitled to receive their missed dividends once the company regained its financial footing. As the company stabilized, GE made good on these arrears, paying the accumulated dividends to its preferred shareholders before resuming any payments to common stockholders. This example highlights how cumulative preferred stock can act as a buffer for investors even in turbulent times.

In this scenario, cumulative preferred shareholders were prioritized over common stockholders in terms of dividend payments, protecting their income stream and ensuring they eventually received what was owed.

Non-cumulative preferred stock, on the other hand, lacks this safety net. If a company skips a dividend payment on non-cumulative preferred shares, the investor forfeits the right to receive that missed payment in the future. While non-cumulative preferred shares can sometimes offer higher yields, the risk is also greater, especially in cases where companies are facing financial difficulties or economic uncertainty.

Example: Bank of America’s Non-Cumulative Preferred Stock

An example of non-cumulative preferred stock can be seen with Bank of America (BAC), which issued various non-cumulative preferred shares. In the event of financial distress or underperformance, if the bank decides to suspend dividends on these shares, the missed payments are not accrued, and investors have no claim to receive those dividends later. This was a notable concern during the 2008 financial crisis when several banks, including Bank of America, suspended their preferred stock dividends to preserve capital.

Non-cumulative preferred stock tends to appeal more to investors who are willing to take on slightly higher risk in exchange for the potential of a higher dividend yield. However, this comes at the cost of less certainty in dividend payments, especially during times of corporate distress.

Key Takeaways

• Cumulative preferred stock offers protection for investors because it guarantees that missed dividends will be paid out before common shareholders receive any dividends. This is beneficial for those looking for a steady and predictable income stream.
• Non-cumulative preferred stock, while sometimes offering higher yields, presents more risk since missed dividends cannot be recovered in the future.

Convertible vs Non-Convertible Preferred Stock

Convertible preferred stock provides a unique advantage to investors by offering the option to convert their preferred shares into a predetermined number of common shares. This can be particularly advantageous when the company's common stock experiences significant price appreciation, giving the investor the potential for capital gains while continuing to benefit from stable dividend payments during the holding period.

For example, if a company’s common stock price rises substantially, investors holding convertible preferred shares can choose to convert them into common shares and benefit from the price increase. This feature adds an element of growth potential to the otherwise income-focused nature of preferred stock, making it an attractive option for investors seeking both income and the possibility of future capital gains.

Example: Tesla’s Convertible Preferred Stock

A notable example of convertible preferred stock comes from Tesla (TSLA). In 2013, Tesla issued convertible preferred shares to raise capital during its earlier growth phase. These shares offered investors regular dividend payments, but more importantly, gave them the option to convert into common shares if Tesla’s stock price increased significantly. As Tesla’s stock surged in subsequent years, investors who had purchased the convertible preferred shares had the opportunity to convert them into common stock, realizing significant gains as Tesla became one of the most valuable companies in the world.

For investors, this scenario illustrates how convertible preferred stock can provide both stability through dividends and growth through capital appreciation, especially if the issuing company experiences strong performance.

On the other hand, non-convertible preferred stock does not offer this option. Investors who choose non-convertible preferred shares are typically seeking a stable, long-term income stream rather than exposure to the potential growth of the company’s common stock. These investors are more focused on the predictable dividend payments that come with preferred stock and are less concerned with capital appreciation.

Example: Bank of America’s Non-Convertible Preferred Stock

An example of non-convertible preferred stock is Bank of America (BAC), which has issued several series of non-convertible preferred shares. These shares are popular with investors who prioritize steady, reliable dividend income over the potential for stock price appreciation. Non-convertible preferred shareholders in Bank of America enjoy relatively high dividend yields, especially compared to common stockholders, but they do not have the option to convert their shares into common stock, even if Bank of America’s stock price increases substantially.

While non-convertible preferred stock can be seen as less flexible, it offers income-focused investors the certainty of consistent dividend payments, making it suitable for those with long-term, stable income goals, such as retirees or conservative investors.

Key Takeaways:

• Convertible preferred stock offers flexibility, allowing investors to convert their shares into common stock and benefit from capital appreciation if the company’s common stock performs well. This feature makes convertible preferred shares appealing to investors who want income stability but also the potential for future growth.
• Non-convertible preferred stock is more focused on providing consistent, long-term dividend income. Investors in non-convertible shares typically prioritize income over growth, making these shares attractive for those seeking stability rather than market-driven gains.

Preferred Stock Dividends: What You Need to Know

One of the primary reasons investors are drawn to preferred stock is the relatively high and consistent dividend payments. Preferred stock dividends are typically fixed, meaning they are set at the time of issuance and remain the same over the life of the security, unless the terms specify otherwise. These fixed payments provide a predictable income stream, which is particularly appealing to income-focused investors, such as retirees or those looking to supplement their income.

Fixed vs. Floating Dividend Rates

While most preferred stocks offer fixed dividend payments, some preferred stocks come with floating dividend rates. These rates fluctuate based on a benchmark interest rate, such as the Secured Overnight Financing Rate (SOFR) or the U.S. Treasury rate. For instance, a floating rate preferred stock might specify that the dividend will be set at a rate of 2% above the current SOFR rate. In a rising interest rate environment, floating-rate preferred stocks become more attractive because their dividends increase along with prevailing interest rates, offering protection against inflation and rising rates.

Payment Frequency and Priority

Preferred stock dividends are typically paid on a quarterly, semi-annual, or annual basis, depending on the issuing company. These payments are prioritized over common stock dividends, meaning that companies must pay preferred stockholders their dividends before distributing any to common shareholders. In the event of financial trouble or limited cash flow, companies may suspend or reduce dividends to common stockholders, but preferred stockholders usually continue to receive their payments, provided the company can afford it.

For cumulative preferred stock, if a company skips a dividend payment, the missed payments accumulate. The company must pay these back to preferred shareholders in full before paying dividends to common shareholders. This gives cumulative preferred stockholders added protection and ensures they receive their due income over time.

Tax Considerations for Preferred Dividends

Another important aspect of preferred stock dividends is their tax treatment. In the U.S., many preferred dividends qualify for favorable tax treatment. These qualified dividends are taxed at a lower rate than ordinary income, typically between 0% and 20% depending on the investor’s taxable income. However, not all preferred dividends are considered qualified. Some preferred dividends may be treated as ordinary income, which is taxed at a higher rate.

The tax implications of preferred dividends can significantly impact the overall return on investment, especially for investors in higher tax brackets. For example, dividends from foreign preferred stock or certain REIT-preferred stock may not qualify for the lower tax rates on qualified dividends. Investors should consult with a tax advisor to fully understand the tax treatment of their preferred dividends and how it fits into their broader tax strategy.

Timing of Dividend Payments and Missed Payments

Dividend payments on preferred stock are generally reliable, but companies can sometimes miss payments due to financial distress. With cumulative preferred stock, any missed dividends accumulate and must be paid out before the company can distribute dividends to common shareholders. This makes cumulative preferred shares a safer option for investors seeking steady income, as they are more likely to receive their dividend eventually, even if payments are temporarily delayed.

With non-cumulative preferred stock, however, if a company skips a dividend payment, those payments are lost forever, and investors cannot recover the missed income. As a result, non-cumulative preferred stock carries more risk, especially for companies in volatile industries or those with uncertain financial futures.

Why Invest in Preferred Stock?

Preferred stock offers several advantages for income-focused investors, including higher yields and greater stability compared to common stock. Additionally, in the event of a company’s liquidation, preferred shareholders have priority over common shareholders, which can provide some downside protection.

Compared to bonds, preferred stock offers the potential for slightly higher yields, while still being less risky than common stock. Also, in an environment of falling rates, preferred stock might be a more attractive option for investors seeking income, as bond yields tend to be lower during these periods. Looking back at the performance of preferreds during the last four rate hiking cycles, after interest rates peak, returns in the preferreds market have been strong for the next two years. On average preferreds have returned over 15% in the two years following the final rate hike of the cycle. This average return increases to over 20% if you exclude the 2005-2008 rate cycle which was impacted by the Global Financial Crisis. While past performance is not a predictor of future outcomes, this data provides a favorable historical foundation.

Risks and Considerations of Preferred Stock

Like any investment, preferred stock carries risks. These include:

• Interest Rate Sensitivity: Preferred stock prices tend to decline when interest rates rise, as the fixed dividend becomes less attractive compared to new issuances with higher yields.
• Credit Risk: If the issuing company faces financial difficulties, preferred shareholders might not receive their expected dividends, and in a worst-case scenario, the value of their shares may drop significantly.
• Liquidity Concerns: Preferred stock is generally less liquid than common stock, meaning it may be harder to sell quickly at a desired price.

In addition, the preferred securities market faces significant concentration risk due to its heavy exposure to the financial sector, particularly banks. Following the 2008 financial crisis, banks and financial institutions issued large amounts of preferred securities to meet regulatory capital requirements. Today, the financial sector makes up over 80% of the U.S. preferreds market, with banks alone accounting for roughly half of this concentration. This reliance on the financial industry poses a substantial risk, especially in the current environment of high interest rates and stressed commercial real estate portfolios. Investors should carefully manage their exposure to the preferreds market, just as they do with concentrated sectors in other parts of their portfolios.

How to Invest in Preferred Stock

Investing in preferred stock is relatively straightforward and can be done through a brokerage account, much like investing in common stock or bonds. However, for those seeking diversification, preferred stock ETFs (Exchange-Traded Funds) offer a convenient option.

Those looking to take advantage of the valuation and yield opportunities present in the preferreds market while also avoiding bank exposure should consider the VanEck Preferred Securities ex Financials ETF (PFXF). PFXF offers investors access to the U.S.-listed preferred securities market that excludes securities issued by financials, which many might find particularly attractive given the current banking concerns.

Beyond the benefits of excluding financials in the current market, ex-financial preferreds generally also offer a number of other benefits over the broad preferreds market that investors might find attractive. Historically higher yield, greater sector diversification and strong relative performance compared to broad preferreds universe.

Conclusion

Preferred stock serves as a hybrid between common stock and bonds, offering investors the benefits of fixed dividend payments along with a priority claim on assets and income over common shareholders. It is especially appealing for income-focused investors seeking a reliable dividend yield with less risk compared to common stock.

The choice between cumulative and non-cumulative, convertible and non-convertible preferred shares depends on the investor's objectives, whether it’s for steady income or potential capital appreciation. Additionally, preferred stock can provide a diversified income stream with less volatility than common stocks but carries risks such as interest rate sensitivity and concentration in certain sectors, particularly financial institutions.

By understanding the various types of preferred stock and their respective features, investors can make more informed decisions about how preferred securities fit into their broader investment strategy. Always consider factors such as dividend yield, credit rating, and market conditions when selecting preferred stock, and diversify to mitigate potential risks.

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