Preferred stocks are special kinds of securities that balance the benefits of stocks and bonds. These types of stocks perform similarly to bonds, while continuing to serve as equity instead of debt.
This makes preferred stock a useful investment for some purposes. It’s inherently risky though, as a company cannot be legally forced to pay dividends in the same way it can be forced to pay bonds.
Types of preferred stock companies can issue to raise capital
There are multiple types of preferred stocks that companies can issue to raise capital. These are as follows:
- Cumulative — This type of preferred stock pays investors both the current year's dividends and any dividends in arrears (unpaid dividends from years prior) before common shareholders are paid.
- Convertible — This type of preferred stock can be converted into a predefined equivalent quantity of common stock. Although convertible preferred stock can make for a more flexible investment, the exact terms and conditions governing when purchased stock can be converted determines whether it’s a sensible investment.
- Callable — These preferred stocks may be purchased back by the company that issued them after a specific date. Callable preferred stocks are generally considered riskier to investors who prefer steady dividend streams. That’s because they can be purchased back by the company for marginally more than par value with little warning once they’ve passed the predefined waiting period.
- Participating — This form of preferred stock carries additional dividends triggered by several factors, including common stock performance and liquidation events.
- Adjustable-Rate (ARPS) — Adjustable rate preferred stock pays dividends that are altered each quarter in accordance with the movement of a predefined "benchmark." This preferred stock category provides stable market valuation thanks to its regularly adjusted payouts.
Advantages and disadvantages of preferred stock
Investors may choose preferred stock for a number of reasons. The following advantages are unique to these kinds of stocks:
- Stability — Preferred stocks are normally quite stable compared to common stocks.
- High yields — These types of stocks offer better dividend yields than common stocks.
- High priority — Preferred stocks take greater precedence than common stock. This makes it easier for investors to count on a steady stream of income from them.
Preferred stocks carry the following disadvantages:
- Stability — This attribute can become a negative when a company's common stock overperforms as the preferred stock may not generate as high of a return.
- No authority — Preferred stock grants investors no voting rights or other authority over a company's operations.
Difference between preferred stock and common stock
Unlike common stock, preferred stock offers more lucrative dividend yields and a higher payment priority as well.
However, preferred stock does not necessarily appreciate at the same rate as common stock. A company's common stock may experience sudden swells in price and other large price movements while the same company's preferred stock remains relatively stable. Low volatility makes preferred stock a safe investment for moderate returns, but it can underperform when common stock exceeds expectations. Another caveat for preferred stock is that it affords investors no voting rights, unlike common stock.
Preferred stock is a viable investment opportunity in the right circumstances. While it’s inherently risky as companies can’t be forced to pay dividends (as they can be with bonds), preferred stocks offer a balance of the benefits of stocks and bonds.
