Preferred Stock: What It Is and How It Works for Income Traders

Preferred stock sits in a unique middle ground between equity and debt. Issued by companies to raise capital, preferred stock offers income-focused investors regular dividend payments alongside a higher claim on assets than common equity. However, these hybrid securities come with specific trade-offs regarding voting rights, interest rate sensitivity, and market growth potential.

If you want to build an income-generating portfolio or trade fixed-income equity hybrids, it helps to know how preferred shares work and how they differ from standard stock.

What Is Preferred Stock?

This security is a class of equity ownership in a corporation that pays a specified, regular dividend. It is known as a hybrid security because it combines features of both common stock (equity ownership on the balance sheet) and corporate bonds (fixed, periodic income payments).

When a corporation issues these shares, it sets a par value, the face amount used to calculate dividends and measure what holders are owed. It is typically $25 per share for retail issuances or $1,000 for institutional issuances. Dividends are calculated as a percentage of this par value or as a fixed dollar amount.

Unlike common stockholders, preferred shareholders have a liquidation preference. If a company undergoes liquidation or bankruptcy, preferred shareholders are paid after bondholders and other creditors, but before common shareholders. However, this priority only matters if assets remain after creditors are paid, so preferred holders may recover only part of their investment, or nothing at all.

How Preferred Stock Works: Dividends & Priority

The defining characteristic of these shares is their dividend payment structure. While common stock dividends fluctuate based on corporate profitability and board decisions, preferred dividends are predetermined.

Dividend Calculation and Types

Preferred dividends come in two forms. One is a fixed dollar amount, such as $1.50 per share each year. The other is a percentage of par value, such as 6% on a $25 par share, which also equals $1.50 per year. These payments are typically distributed quarterly.

Preferred shares generally fall into two main dividend structures:

1. Cumulative Preferred Shares: If a board suspends dividends due to cash flow constraints, unpaid dividends accumulate as "dividends in arrears". The company must pay all accumulated preferred dividends before paying any dividends to common stockholders.
2. Non-Cumulative Preferred Shares: If a company skips a dividend payment, the investor forfeits that payout permanently. The company is not obligated to make up missed payments in future quarters.

Dividend Suspension vs. Bond Default

A critical legal distinction exists between preferred dividends and bond coupons. A board of directors can choose to suspend preferred dividends during financially difficult periods without declaring bankruptcy. By contrast, missing a coupon payment on a corporate bond is a breach of the bond contract. If the payment isn't made within the grace period set in the bond terms, bondholders can typically take legal action, which may push the issuer into restructuring or bankruptcy.

Preferred Stock vs. Common Stock

Common stock vs preferred stock comes down to a trade-off: income security on one side, capital appreciation and voting control on the other.

Common stock represents residual ownership, meaning common shareholders own whatever is left after creditors and preferred shareholders are paid. Common shareholders hold voting rights to elect board members and benefit directly from corporate growth through rising share prices. Preferred shares, by contrast, trade more like a fixed-income instrument, moving in response to interest rate changes rather than corporate earnings growth alone.

While preferred shares offer priority over common equity, they rarely experience the explosive capital gains seen in high-growth common stocks. Conversely, when markets decline, preferred share prices tend to be less volatile than common equity, provided the issuer remains creditworthy.

Variations of Preferred Shares

Corporations issue several structural variations of these shares to attract different classes of investors:

• Callable Preferred Shares: The issuer can buy back (call) the preferred shares after a set date, usually at par value plus a small premium. Issuers typically do this when market interest rates drop, so they can re-issue new shares at lower yields.
• Convertible Preferred Shares: Shareholders have the option to exchange their preferred shares for a fixed number of common shares under specific conditions. This structure allows income traders to secure regular yield while maintaining an avenue to participate in common stock upside.
• Adjustable-Rate Preferred Shares: Dividend payouts are pegged to a benchmark rate, such as U.S. Treasury yields, providing a buffer against rate fluctuations.

Traders looking for diversified exposure to this asset class often trade a preferred stock ETF rather than selecting individual company issuances. To see how funds like these differ from index funds, read our guide on ETF vs index fund. ETFs pool multiple preferred issues, reducing individual issuer credit risk while providing exposure to broader market yields.

Key Risks for Preferred Stock Investors

Preferred shares carry distinct risks that income traders must evaluate before allocating capital:

• Interest Rate Risk: Because preferred dividends are fixed, share prices move inversely to interest rates. When interest rates rise, existing preferred shares paying lower fixed yields drop in price.
• Call Risk: If interest rates fall, issuers may call back high-yielding preferred shares, leaving investors forced to reinvest capital at lower prevailing rates.
• Subordination Risk: Preferred shares sit lower in the capital structure than all corporate debt. In a bankruptcy scenario, bondholders are paid before preferred holders receive any remaining funds.
• Dividend Suspension Risk: A board can suspend preferred dividends during sustained economic downturns without triggering corporate insolvency. On non-cumulative shares, missed payments are lost for good. On cumulative shares, they build up as arrears.

Conclusion

Preferred shares sit between stocks and bonds, offering regular dividend income with a higher claim on assets than common shares. When you compare preferred shares or preferred ETFs, check whether dividends are cumulative, when shares can be called, and how interest rates could move prices. For the basics behind these choices, see our guide to markets and instruments.

Trading financial instruments involves market risk, including interest rate sensitivity and potential loss of capital. Always conduct thorough research and review individual issuance prospectuses before opening positions.