Preferred Stock

Preferred stock is a class of company shares that gives its holders priority over common shareholders in two ways: they must be paid their dividends before any dividend goes to common stock, and they are repaid before common shareholders if the company is wound up. In return, preferred shares usually carry no vote and limited upside. They are known as preference shares in the UK and many other markets.

Preferred stock is often described as a hybrid. Like bonds, it usually pays a fixed amount based on a stated value and its price moves with interest rates. Like common stock, it is equity: it ranks behind all creditors, and missing a preferred dividend is not a default. Companies, especially banks, insurers and utilities, issue it to raise capital without diluting voting control or adding debt to the balance sheet.

Picture a bakery that owes money to its flour supplier and is owned by a group of partners. Before any partner takes profit, a few special backers who put in money on agreed terms get a set payment each year. The supplier still gets paid first of all, but the special backers come before the ordinary partners.

Those special backers hold the equivalent of preferred stock. Their payment is predictable, and they are safer than the ordinary partners if the bakery closes. But they usually have no say in how the bakery is run, and if it becomes hugely successful, their payment stays the same while the ordinary partners enjoy the extra profit.

Each preferred share has a stated or liquidation value, often $25 or $1,000 in the US market, and a dividend rate set as a percentage of that value. A 6% preferred share with a $25 stated value pays $1.50 a year, usually in quarterly instalments. The board must still declare each dividend, but while preferred dividends are unpaid, the company normally cannot pay a dividend on its common stock.

Because the payment is fixed, the market price of a preferred share tends to fall when interest rates rise and rise when rates fall, the same interest rate risk faced by bondholders. Many preferred issues are perpetual, with no maturity date, which makes them especially sensitive to rate changes. Rating agencies give preferred shares a credit rating, typically a notch or more below the same company's senior bonds because preferred holders stand further back in line.

• Cumulative preferred. Any skipped dividend accumulates as arrears, and the company must pay all of it before common shareholders receive anything.
• Non-cumulative preferred. A skipped dividend is lost for good. Banks often issue this kind because it counts more readily towards regulatory capital.
• Convertible preferred. The holder can swap each share for a set number of common shares, which gives some of the upside of common stock, much as a convertible bond does.
• Callable preferred. The issuer can buy the shares back at a set price after a set date, which it is likely to do when rates fall and it can refinance more cheaply.
• Participating preferred. Holders receive their fixed dividend and can also share in extra profit above a threshold. This form is common in venture capital deals, where investors negotiate preferred shares with liquidation preferences.
• Fixed-to-floating and adjustable-rate preferred. The dividend is fixed for an initial period and then resets against a benchmark rate.

Under the Basel III framework, banks can count perpetual, non-cumulative preferred shares as Additional Tier 1 capital, provided the shares meet strict conditions: the bank must be free to cancel dividends, and there can be no incentive to redeem. That is why large banks are among the biggest issuers of preferred stock in the US. In Europe, banks raise similar capital mainly through contingent convertible instruments, which convert or are written down when capital falls too low. The treatment ties preferred stock closely to the wider rules on bank capital.

Preferred shares appeal to income-seeking investors who want a higher yield than senior bonds from the same company. In the US, dividends on many preferred shares can be "qualified dividends" taxed at lower rates, which adds to their appeal for individuals. Investors can buy them through a broker or through an exchange-traded fund (ETF) or mutual fund that specialises in them. Main risks include:

• Subordination. In a failure, preferred holders are paid only after creditors, and may receive little or nothing.
• Rate sensitivity. Long or perpetual preferred shares can lose much of their value when interest rates rise.
• Call risk. Issuers tend to redeem callable shares when it suits them, cutting off the income just as rates fall.
• Thin trading. Many issues are small and trade thinly, so liquidity is limited and prices can be wide and volatile.

Investors compare preferred shares with a corporate bond from the same issuer, since both offer fixed payments, and weigh the extra income against the weaker legal claim. Preferred holders are still shareholders, with the rights described under Shareholder (Stockholder), but those rights are narrower than those attached to common stock.

• Investor.gov (U.S. Securities and Exchange Commission): Stocks
• Bank for International Settlements: Basel III framework