In the Media - Preferred Stock vs. Common Stock: What's the Difference (U.S. News)
Our very own Marcus Holzberg, CFP® was recently featured in an article from the U.S. News and World Report about preferred stock.
Investing in 'stocks' refers to taking partial ownership (or equity) in a corporation. Stocks come in two forms: common and preferred. Common stocks are what you generally think of when you invest in the equity markets -- you purchase shares of a company representing ownership in said corporation. Preferred stock (also known as 'preferred shares' or simply 'preferreds'), on the other hand, combines properties of common stock and bonds.
What Is A Preferred Stock?
Just like an ordinary (common) stock, preferred stock represents shares of company ownership. However, preferreds have some additional features for shareholders. For example, preferreds get priority in dividend payments over common shareholders. If a company only has enough cash flow to either pay the common or the preferred shareholders, the company will always pay the preferred first. Also, if something happens to the company and it is forced to liquidate its assets to pay its shareholders, preferred stockholders rank higher in the company's capital structure and, therefore, would be paid out before common shareholders.
Investments of any kind come with risks. However, preferreds are generally considered less risky than common stocks of the same company, but more risky than bonds. Moreover, preferred stocks are usually more suitable for investors interested in income over capital appreciation, similar to investors with bond allocations. Also, gains on preferreds are generally more limited than common stock because preferred stock prices are more closely tied to changes in interest rates, and the price of the preferred changes more slowly. Therefore, by investing in preferreds, you forgo the uncapped upside potential of common stock and the safety of bonds.
How Does Preferred Stock Work?
Preferred stocks combine certain aspects of common stocks and bonds. They are called 'hybrid securities' as they offer equity in the company while providing a steady and consistent dividend income resembling interest payments on bonds. They are issued by corporations that already have outstanding common stock, and unlike common stock, they usually do not have voting rights.
Like bonds, preferred stocks are issued by corporations at a set face amount, known as 'par value.' Once issued, they can be purchased and sold in the secondary marketplace, just like common stocks. This presents an opportunity for savvy investors to buy quality preferreds, when under certain circumstances, they are selling at a discount to par (meaning the preferred is currently selling for less than the amount it was issued for) and, therefore, can provide excellent total return.
Preferreds regularly pay dividends, making them more attractive for fixed-income investors. That said, like bonds, preferreds typically have an inverse relationship with interest rates. As interest rates rise, the price of existing bonds and preferreds decreases, and vice versa. Unlike bonds, however, preferreds typically have no maturity date; if they do, they are quite long. Therefore, they can be volatile when interest rates change. Since preferreds are usually perpetual, some preferreds are callable, meaning the company can repurchase the shares from the shareholder. After a specific date, known as the call date, the company may redeem the callable preferred at or above par. This call price may be different from the market price of the preferred, although it will always be at par or greater.
The board of directors of public companies set dividends for common stocks. How the company is performing and how much it wants to incentivize shareholders to hold onto the stock can determine whether it raises, reduces, or eliminates the dividend entirely. However, preferred stocks are issued with dividends at a stated rate that are usually higher than dividends on the common stock of the same company. With that said, these dividends are not guaranteed.
Some preferreds are cumulative. This means that when the issuing company cannot pay dividends to preferred shareholders, they can postpone the payment until the company is healthier. If the company misses a cumulative preferred dividend payment, that dividend is said to be in arrears and must be paid in full prior to any payment whatsoever of common dividends. Conversely, for non-cumulative preferreds, the company can skip a dividend payment entirely without any further obligations. However, the downside for the company in doing this is that it makes it more challenging to raise money in the future.
Preferred stocks may also have an added provision that they can be converted for common shares. This is referred to as the stock being convertible -- meaning it can be 'converted' for a specified number of common shares at a predetermined price known as the conversion price. The upside to convertibility for investors is that you get increased income with preferreds and upside potential beyond the conversion price. However, this usually means these preferreds come with lower dividend rates than other preferred stock offerings of the same company.
Similar to bonds, a corporation may have more than one offering of preferreds. Each preferred will likely have different features (i.e., different yields, callability, convertibility). Moreover, most preferreds (especially preferreds of larger companies) are issued with a credit rating based on the company's creditworthiness. These securities are rated by independent companies, the most well-known of which are Moody's and Standard and Poors.
Preferred Stock vs. Common Stock vs. Bonds
Ownership Stake in the Company
Upside Growth Potential
Limited, unless convertible or bought below par.
Limited, unless convertible or bought below par.
Risk (of the same company)
Priority in the Event of Bankruptcy
Paid out after bondholders and before common shareholders.
Lowest. Paid out last if funds remain after paying back bond and preferred holders.
Highest. Paid out before preferred and common shareholders.
Stated dividends, often with higher yields than bonds and common stocks of the same company.
Many companies pay little or no common dividends.
Stated interest payments that must be paid prior to the payment of any dividends.
Most companies do not issue shares of preferred stock, so their market is relatively small. They can be purchased in most investment accounts and can be beneficial for individuals who need current income. There are some industries where they are more customary, including financial institutions (like banks and insurance companies), utilities, and real estate investment trusts (REITs). Investors can further diversify their portfolios by purchasing exchange-traded funds (ETFs) or mutual funds that purchase many preferred stocks, which gives you the advantage of buying a professionally managed pool of preferred stocks rather than taking the investment risk of just one offering.
Preferred stocks also have some notable tax advantages. Many preferred stocks pay out qualified dividends, which are taxed more favorably than ordinary dividends. If the preferred stock pays out a qualified dividend, the dividends will be taxed at up to 20% of the dividend received, depending on your tax bracket.
Meanwhile, regular (non-qualified) dividends are taxed at your ordinary income tax rate. At the end of each year, you will receive a Form 1099 from your brokerage firm for your taxable account(s). On that statement will be Form 1099-DIV which outlines the dividends and distributions received in the account(s). You can find the qualified dividends received on line 1b of Form 1099-DIV.
Pros and Cons of Investing in Preferred Stocks
If you have questions about whether investing in preferred stocks may be right for you, talk with a financial advisor. You can schedule a complimentary, no-obligation call with us here!
About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
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