Preferred stock, also called preferred shares, preference shares, or simply
preferreds, is a special equity security that has properties of both an equity and a debt
instrument and is generally considered a hybrid instrument. Preferred are senior (i.e.
higher ranking) to common stock, but are subordinate to bonds.
Preferred stock usually carries no voting rights, but may carry a dividend and may
have priority over common stock in the payment of dividends and upon liquidation.
Preferred stock may have a convertibility feature into common stock. Terms of the
preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit rating companies.
The rating for preferred is generally lower since preferred dividends do not carry the
same guarantees as interest payments from bonds and they are junior to all creditors.
Preferred stock is a special class of shares that may have any combination of
features not possessed by common stock.
The following features are usually associated with preferred stock
Preference in dividends.
Preference in assets in the event of liquidation.
Convertible into common stock.
Callable at the option of the corporation.
In general, preferred have preference to dividends payments. A preference does not
assure the payment of dividends, but the company must pay the stated dividend rate prior
to paying any dividends on common stock.
Preferred stock can either be cumulative or non-cumulative. A cumulative preferred
stock requires that if a company fails to pay any dividend or any amount below the stated
rate, it must make up for it at a later time. Dividends accumulate with each passed
dividend period, which can be quarterly, semi-annually, or annually.When a dividend is
not paid in time it is said that the dividend has "passed" and all passed dividends on a
cumulative stock is a dividend in arrears. A stock that doesn't have this feature is known
as a non-cumulative or straight preferred stock and any dividends passed are lost forever
if not declared.
Other features or rights
Preferred stock may or may not have a fixed liquidation value, or par value,
associated with it. This represents the amount of capital that was contributed to
the corporation when the shares were first issued.
Preferred stock has a claim on liquidation proceeds of a stock corporation,
equivalent to its par or liquidation value unless otherwise negotiated. This claim is
senior to that of common stock, which has only a residual claim.
Almost all preferred shares have a negotiated fixed dividend amount. The
dividend is usually specified as a percentage of the par value or as a fixed amount.
For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends
on preferred shares may be negotiated as floating i.e. may change according to a
benchmark interest rate index such as LIBOR.
Some preferred shares have special voting rights to approve certain extraordinary
events (such as the issuance of new shares or the approval of the acquisition of the
company) or to elect directors, but most preferred shares provide no voting rights
associated with them. Some preferred shares only gain voting rights when the
preferred dividends are in arrears for a substantial time.
Types of Preferred Stock:
In addition to the straight preferred, as just described, there is great diversity in the
preferred stock market. Additional types of preferred stock include:
Prior Preferred Stock—Many companies have different issues of preferred
stock outstanding at the same time and one of them is usually designated to be the
one with the highest priority. If the company has only enough money to meet the
dividend schedule on one of the preferred issues, it makes the dividend payments
on the prior preferred. Therefore, prior preferred have less credit risk than the
other preferred stocks but it usually offers a lower yield than the others.
Preference Preferred Stock—Ranked behind the company's prior preferred
stock (on a seniority basis), are the company's preference preferred issues. These
issues receive preference over all other classes of the company's preferred except
for the prior preferred. If the company issues more than one issue of preference
preferred, then the various issues are ranked by their relative seniority. One issue
is designated first preference, the next senior issue is the second and so on.
Convertible Preferred Stock—These are preferred issues that the holders can
exchange for a predetermined number of the company's common stock. This
exchange can occur at any time the investor chooses regardless of the current
market price of the common stock. It is a one way deal so one cannot convert the
common stock back to preferred stock.
Cumulative preferred stock—If the dividend is not paid, it will accumulate for
Exchangeable preferred stock—This type of preferred stock carries an
embedded option to be exchanged for some other security upon certain
Participating Preferred Stock—These preferred issues offer the holders the
opportunity to receive extra dividends if the company achieves some
predetermined financial goals. The investors who purchased these stocks receive
their regular dividend regardless of how well or how poorly the company
performs, assuming the company does well enough to make the annual dividend
payments. If the company achieves predetermined sales, earnings or profitability
goals, the investors receive an additional dividend.
Perpetual preferred stock—This type of preferred stock has no fixed date on
which invested capital will be returned to the shareholder, although there will
always be redemption privileges held by the corporation. Most preferred stock is
issued without a set redemption date.
Putable preferred stock—These issues have a "put" privilege whereby the
holder may, upon certain conditions, force the issuer to redeem shares.
Monthly income preferred stock—A combination of preferred stock and
Non-cumulative preferred stock—Dividend for this type of preferred stock will
not accumulate if it is unpaid. Very common in TRuPS and bank preferred stock,
since under BIS rules, preferred stock must be non-cumulative if it is to be
included in Tier 1 capital.
Preferred stocks offer a company an attractive alternative to financing. In most
cases, a company can defer dividends by going into arrears without much of a penalty or
risk to their credit rating. With traditional debt, payments are required and a missed
payment would put the company in default.
Occasionally companies use preferred shares as means of preventing hostile takeovers,
creating preferred shares with a poison pill or forced exchange or conversion features that
exercise upon a change in control. Some corporations contain provisions in their charters
authorizing the issuance of preferred stock whose terms and conditions may be
determined by the board of directors when issued. These "blank checks" are often used as
takeover defense (see also poison pill). These shares may be assigned very high
liquidation value that must be redeemed in the event of a change of control or may have
enormous supervoting powers.
Sometimes preferred shares can contain protective provisions which prevent the issuance
of new preferred shares with a senior claim. Individual series of preferred shares may
have a senior, pari-passu or junior relationship with other series issued by the same
Preferred shares are more common in private or pre-public companies, where it is more
useful to distinguish between the control of and the economic interest in the company.
Government regulations and the rules of stock exchanges may discourage or encourage
the issuance of publicly traded preferred shares. In many countries banks are encouraged
to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv
Stock Exchange prohibits listed companies from having more than one class of capital
A single company may issue several classes of preferred stock. For example, a company
may undergo several rounds of financing, with each round receiving separate rights and
having a separate class of preferred stock; such a company might have "Series A
Preferred," "Series B Preferred," "Series C Preferred" and common stock.
In the United States, there are two types of preferred stocks: straight preferred and
convertible preferred. Straight preferred are issued in perpetuity (although some are
subject to call by the issuer under certain conditions) and pay the stipulated rate of
interest to the holder. Convertible preferred—in addition to the foregoing features of a
straight preferred—contain a provision by which the holder may convert the preferred
into the common stock of the company (or, sometimes, into the common stock of an
affiliated company) under certain conditions, among which may be the specification of a
future date when conversion may begin, a certain number of common shares per
preferred share, or a certain price per share for the common.
There are income tax advantages generally available to corporations that invest in
preferred stocks in the United States that are not available to individuals.
Some argue that a straight preferred stock, being a hybrid between a bond and a stock,
bears the disadvantages of each of those types of securities without enjoying the
advantages of either. Like a bond, a straight preferred does not participate in any future
earnings and dividend growth of the company and any resulting growth of the price of the
common. But the bond has greater security than the preferred and has a maturity date at
which the principal is to be repaid. Like the common, the preferred has less security
protection than the bond. But the potential of increases of market price of the common
and its dividends paid from future growth of the company is lacking for the preferred.
One big advantage that the preferred provides its issuer is that the preferred gets better
equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as
pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows
financial institutions to satisfy regulatory requirements without diluting common
shareholders. Said another way, through preferred stock, financial institutions are able to
put on leverage while getting Tier 1 equity credit.
Suppose that an investor paid par ($100) today for a typical straight preferred.
Such an investment would give a current yield of just over 6%. Now suppose that in a
few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these
preferred would yield at least 13%, which would knock their market price down to $46,
for a 54% loss. The important difference between straight preferred and Treasuries (or
any investment-grade Federal agency or corporate bond) is that the bonds would move up
to par as their maturity date is approached, whereas the straight preferred, having no
maturity date, might remain at these $40 levels (or lower) for a very long time.
Advantages of straight preferred posited by some advisers include higher yields
and tax advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of
common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather
than at ordinary income rates, as in the case of bond interest).