A preferred stock is a type of stock that includes features of both an equity and a debt instrument. It is generally considered to be a hybrid instrument. It is a stock that entitles the holder to a fixed dividend, similar to a debt instrument, but also has the ability to appreciate over time, like an equity. A preferred stock gives ownership in a corporation like a common stock, but it has a higher claim on assets and earnings than a common stock does. The details of each preferred stock will vary with the issue/offering.
The important thing about preferred stock is that it combines features from both debt and equity. In debt, it pays fixed dividends. In equity, it has the potential to increase in price.
The advantages of preferred over common stock, is the rights to company assets. Preferred shareholders have a claim to a company’s assets if it is liquidated over common shareholders. The order of rights to company assets is first, bondholders then preferred shareholders then lastly, common shareholders. Also, preferred stocks offer a more predictable stream of income, via fixed dividends. Dividends paid to preferred shareholders are usually higher than dividends received by common shareholders. Also, these dividends for preferred shareholders can be paid quarterly or monthly.
The disadvantage of a preferred compared to a common, is that preferred shareholders do not carry voting rights.
There are four preferred stock classes:
Cumulative is defined as, such shares allow owners to accumulate dividend payments that may have skipped because of financial hurdles.
Non-Cumulative is defined as, these shared do not give owners access to any skipped dividends.
Convertible is defined as, these shares can be transformed into a determined number of common stock.
Participating is defined as, such shares get higher-than-average dividends compensation if a company generates a large-than-projected profit.
Also, there are a few risks to consider when investing in preferred stocks. First, if a company ever faced financial trouble before they cut the interest payments to bondholders they are going to cut the dividend payment for preferred shareholders. This is when a cumulative preferred comes into play. If a company skips a dividend payment owed to the preferred shareholders, they must make it up before they pay any common shareholder dividends. Second, there is a low trading volume in preferred shares. Which could result in you being forced to pay a slightly higher price. Third, rising interest rates could drive the price of preferred stocks lower. Lastly, you want to know that many preferred stocks are offered by financial companies. So when you are building a portfolio, you should remember that if you invest in preferred stocks and also buy commons of financial companies, you will have double the risk in that particular industry.