When people refer to stocks, its almost always common stock they are discussing. But it’s not the only type of stock you can own. Preferred stock is the other possibility and it’s popular with income investors.
A company has several options when it needs to raise cash. It can take on debt by borrowing from a bank, it can issue bonds, or it can issue stock.
Issuing common stock comes with one big disadvantage. It dilutes shareholder value which never goes over well with existing shareholders.
The alternative is to issue preferred stock with an annual dividend and set price. Once issued, the shares are bought and sold on an exchange like any another stock.
This fixed dividend is what separates the common stock and preferred stock. In exchange for that dividend, preferred shareholders give up any future earnings growth in the company. While both have a claim on earnings and assets, the “preferred” in preferred stock gives it seniority over common stock. In that regard preferred shares are more like bonds. And like a bond, preferred shares can carry a maturity date also.
This is why preferred stock is seen as a hybrid, taking on characteristics of both common stock and bonds. And why it’s favored more by income investors.
- Less Volatility – since price is determined by the dividend, which is fixed, prices tend to be more stable than common stock.
- Fixed Dividend – provides a relatively reliable higher yield in exchange for little to no price appreciation.
- Dividend Priority – preferred shareholders have priority over common stock when it comes to dividend payments and bankruptcy.
- Convertible – some preferred shares, known as convertible preferred, can be redeemed for a fixed number of common shares after a set date. This ties the preferred share price to the common stock price.
- Callable – most preferred shares have a call date, this allows the company to buy the shares back before maturity at a set price.
- Dividends Aren’t Guaranteed – like any dividend, it’s dependent on the company’s ability to make enough money to actually pay it. Some preferred stock are known as cumulative, where any unpaid dividends add up and are eventually paid if/when the company is financially able.
- Interest Rate Risk – like bonds, since the fixed dividend is used to decide the share price, this leaves preferred shares susceptible to interest rate changes. Learn more about interest rate risk.
- Limited Growth – price is based on a fixed dividend which limit capital gains. The exception is a convertible preferred that can be exchanged for common stock.
- No Voting Rights – fairly self-explanatory, preferred shareholders don’t get to vote on corporate matters.
How To Buy Preferred Stock
There are a couple of ways to own preferred stock. To start, the shares are bought through any broker. Keep in mind, it’s quite common to see very little volume for these shares. This can limit the availability and have a higher spread between the bid/ask price. With that, you just need the ticker symbol and your limit order price.
The alternative is an ETF. If the volume is too low or you just want a basket of preferreds, there are several ETFs that specialize in just that. You can use an ETF screener to find one that fits your portfolio.