Preferred Stock
Preferred stock is a hybrid security that blends characteristics of both common stock and bonds, offering fixed dividend payments with priority over common shareholders in receiving dividends and assets during liquidation.
Key Formula
Example: A preferred stock with a $5 annual dividend trading at $100 has a 5% current yield. If the price drops to $90, the yield rises to 5.56%.
Example
Bank of America Series L preferred stock (BAC-L) has a fixed dividend of $1.75 per share per year. If you buy 100 shares at $25 each ($2,500 total), you receive $175 annually in dividends — a 7% yield. These dividends must be paid before any dividends go to common shareholders. If BAC suspends the preferred dividend, they cannot pay any common stock dividend until all missed preferred dividends are paid.
How to Interpret It
Preferred stock sits between bonds and common stock in a company's capital structure. It offers higher income than common stock (typically 4–7% vs. 1–3%) but less upside potential. Unlike bonds, preferred dividends can be suspended (for non-cumulative issues), and unlike common stock, preferred shares rarely appreciate significantly. They're best suited for income-focused investors who want higher yields than bonds with some equity-like features.
Why It Matters
Preferred stock plays a unique role in portfolio construction, particularly for income-seeking investors. Banks and financial institutions are the largest issuers of preferred stock because it counts as Tier 1 capital for regulatory purposes — it strengthens their balance sheet while providing investors with above-average yields. For investors, preferred stocks often yield 1–3 percentage points more than the same company's bonds, compensating for the higher risk of dividend suspension versus bond default.
The interest rate sensitivity of preferred stock is a critical consideration. Because preferred dividends are typically fixed (like bond coupons), their prices move inversely with interest rates. When the Federal Reserve raised rates aggressively in 2022–2023, many preferred stocks fell 15–25% as their fixed dividends became less attractive relative to rising bond yields. Conversely, when rates fall, preferred stocks can appreciate significantly. This rate sensitivity makes preferred stocks a tactical tool for investors with views on interest rate direction.
Tax treatment is another important factor. For individual investors, qualified preferred stock dividends may be taxed at the lower capital gains rate (15–20%) rather than ordinary income rates (up to 37%), giving them a tax advantage over bonds. However, not all preferred dividends qualify — the company must be a U.S. corporation and meet holding period requirements.
Types of Preferred Stock
- Cumulative: Missed dividends accumulate and must be paid before common dividends resume. This is the most common type and provides significant protection.
- Non-Cumulative: Missed dividends are permanently lost. More common in bank-issued preferreds. Higher risk but typically higher yield to compensate.
- Convertible: Can be exchanged for a predetermined number of common shares, offering upside participation if the stock price rises significantly.
- Callable: The issuer can redeem the shares at a set price after a call date, capping upside and reinvestment risk.
Real-World Example
During the 2008 financial crisis, Warren Buffett invested $5 billion in Goldman Sachs preferred stock with a 10% dividend and warrants to buy common stock. Goldman paid Buffett $500 million per year in dividends and later redeemed the preferred shares at a premium, while the warrants generated billions more. This illustrated how preferred stock can offer attractive risk-reward: Buffett received a high fixed income with seniority over common shareholders, plus equity upside through the warrants.
Common Mistakes
- Treating preferred stock like common stock: Preferred shares rarely appreciate. Buying them for capital gains will disappoint — they're income instruments. Expect price stability (in stable rate environments) and regular dividends, not growth.
- Ignoring interest rate risk: Fixed-rate preferred stocks are highly sensitive to interest rate changes. A 1% rise in rates can cause a 10–15% price decline. Consider floating-rate preferreds if you expect rates to rise.
- Not checking call provisions: Many preferreds are callable after 5 years. If you buy above the call price, you could face a loss when the shares are called. Never pay significantly above the call price.
- Overlooking credit quality: Preferred stock is subordinate to all debt. In a bankruptcy, preferred shareholders may receive little or nothing. Check the company's credit rating and financial health before buying.
Pro Tips
Consider preferred stock ETFs: ETFs like PFF (iShares Preferred) or PGX (Invesco Preferred) provide instant diversification across 100+ preferred issues, reducing company-specific risk while maintaining attractive yields of 5–7%.
Buy below par value: Most preferreds are issued at $25 (par). Buying below par ($22–$24) provides a higher current yield and potential capital appreciation if the shares return to par. Avoid buying well above par.
Focus on cumulative preferreds: Cumulative preferred stock protects you from missed dividends — they must eventually be paid. Non-cumulative preferreds carry unnecessary risk for the modest yield premium.
Frequently Asked Questions
What is a preferred stock?
A hybrid between stocks and bonds. Preferred stocks pay fixed dividends (like bond coupons) and have priority over common stock for dividends and liquidation. However, they typically don't have voting rights and have limited upside compared to common stock. Yields are usually 5-7% — higher than common stock dividends but lower than junk bonds.
Preferred vs. common stock?
Common stock offers voting rights and unlimited upside potential. Preferred stock offers higher, more stable dividends and priority in bankruptcy. In practice: if a company suspends dividends, preferred shareholders must be paid in full before common shareholders receive anything. Preferred is for income investors; common is for growth investors.
Are preferred stocks safe?
Safer than common stock of the same company (priority in liquidation), but riskier than bonds (bondholders have higher priority). Preferred dividends can be suspended (unlike bond interest payments which trigger default). Bank preferred stocks are popular because banks have strong balance sheets and the dividends qualify for preferential tax rates.