How to Buy Preferred Stock: A Step-by-Step Process

Understanding Preferred Stock

Preferred stock represents a unique ownership stake in a company, positioned distinctly between common stock and corporate bonds. Unlike common stockholders who have voting rights and fluctuating dividends, preferred stockholders typically receive fixed dividend payments. These dividends are paid out before any common stockholders receive their share, offering a predictable income stream for investors.

In scenarios where a company faces liquidation, preferred stockholders hold a superior claim on the company’s assets compared to common stockholders. Their claims are settled after bondholders but before common equity holders, providing a layer of security. However, this enhanced security and fixed income stream usually come at the expense of voting rights, meaning preferred stockholders generally do not participate in company governance decisions.

The design of preferred stock blends characteristics of both equity and debt instruments. While it is a form of equity because it represents ownership, its fixed dividend payments and priority in liquidation resemble the fixed income and repayment priority associated with bonds. This hybrid nature makes preferred stock an appealing option for investors seeking a balance between income generation and capital preservation. It offers a different risk-reward profile than either common stocks or bonds, attracting investors with specific financial objectives.

Types of Preferred Stock

Preferred stock comes in several forms, each with distinct features that influence its appeal to investors. One common type is cumulative preferred stock, where any missed dividend payments accumulate over time. The company must pay all accumulated past and current preferred dividends before it can distribute any dividends to common stockholders. This feature provides an added layer of protection for investors seeking consistent income.

In contrast, non-cumulative preferred stock does not accrue missed dividends. If the company fails to pay a dividend, that payment is typically lost forever, and the company is not obligated to make up for it later. This type carries more risk for income-focused investors, as their expected payments are not guaranteed to be recovered if missed.

Convertible preferred stock offers investors the option to convert their preferred shares into a predetermined number of common shares. This feature allows investors to potentially participate in the company’s growth if its common stock appreciates significantly. The conversion option provides a pathway from fixed income to potential capital gains, blending two investment objectives.

Callable preferred stock grants the issuing company the right to repurchase the shares at a specified price on or after a certain date. This call provision can limit the potential for capital appreciation and may force investors to reinvest their capital at potentially lower rates. Investors must understand the call schedule and price to assess this risk.

Participating preferred stock allows holders to receive additional dividends beyond their stated fixed rate under certain conditions, such as the company achieving specific profit targets. This offers a chance for increased income, although the conditions for participation vary widely. Another type is adjustable-rate preferred stock, where the dividend rate fluctuates based on a benchmark interest rate, like the London Interbank Offered Rate (LIBOR) or a similar index. This feature helps protect investors from rising interest rates, as their dividend income can increase accordingly.

Evaluating Preferred Stock Investments

Thorough evaluation of several factors is important before investing in preferred stock. Credit ratings from agencies like S&P Global Ratings, Moody’s, and Fitch Ratings assess the issuer’s financial stability and ability to meet obligations. A higher rating indicates lower default risk, important for consistent dividend payments. Checking these ratings helps gauge the likelihood of regular income.

Understanding dividend yield is also important. It is calculated by dividing the annual dividend payment by the stock’s current market price. Comparing yields across different preferred stocks helps identify competitive income streams. However, a very high yield might signal higher issuer risk.

Call provisions are another important element. Investors should identify the specific call date and price, the earliest date and price the company can repurchase shares. If a preferred stock is called, investors receive the call price, which may be less than current market value, potentially limiting returns or forcing reinvestment. Analyzing these provisions helps understand investment duration.

Reviewing the issuer’s financial health is important for assessing its long-term viability and capacity to pay dividends. This involves examining financial statements: balance sheet, income statement, and cash flow statement. Investors should look for consistent profitability, manageable debt, and strong cash flow, as these suggest the company’s ability to sustain dividend payments. Industry stability and economic outlook also influence financial performance.

Preferred stock dividends are generally taxed as ordinary income, similar to bond interest. However, some preferred dividends may qualify for lower qualified dividend tax rates, typically the same as long-term capital gains. This depends on factors like stock holding period and whether the issuer is a U.S. or qualified foreign corporation. Investors should consult tax professionals for specific tax treatment.

How to Buy Preferred Stock

Purchasing preferred stock begins with opening a brokerage account. Investors can choose between online discount brokers for lower fees and self-directed trading, or full-service brokers for personalized advice. Account opening involves providing personal information like social security number, address, and financial details to comply with regulations.

Once established, the account must be funded. Common methods include electronic transfers from a bank account (1-3 business days to clear) or wire transfers (faster, may incur fees). Mailing a check is another option, though slowest. Brokerage firms provide clear instructions for depositing funds.

After funding, investors can search for preferred stock. Brokerage platforms offer tools to search by ticker symbol, company name, or specialized screeners. These screeners filter preferred stocks by criteria like dividend yield, credit rating, industry, or call features, narrowing choices. Utilizing these tools streamlines selection, helping investors find preferred stocks aligning with their objectives.

Understanding different order types is important when placing an order. A market order instructs the broker to buy immediately at the best available price, offering quick execution but no price guarantee. A limit order specifies the maximum price an investor will pay, ensuring the trade executes only if the stock reaches that price or lower. Limit orders provide price control, useful for preferred stocks with less liquidity.

To place an order, investors navigate to the trading section of their brokerage platform. Input the security’s ticker symbol, number of shares, and chosen order type. If using a limit order, enter the desired price per share. After reviewing details, submit the order. Upon successful completion, investors receive a trade confirmation, detailing the transaction, price, quantity, and total cost.