What Is a Preferred Security and How Does It Work?

Preferred securities are financial instruments blending characteristics of traditional stocks and bonds, offering investors a unique position within a company’s capital structure. They provide features not typically found in common equity or corporate debt.

Understanding Preferred Securities

Preferred securities derive their “preferred” designation from their advantaged position relative to common shareholders. These securities typically pay a fixed dividend rate, which remains consistent over time, much like the interest payments on a bond. This fixed dividend is usually expressed as a percentage of the security’s par value, a face value set at issuance and used for calculating these regular payments. Unlike common stock dividends, which fluctuate and are discretionary, preferred dividends are generally more stable and predictable.

Holders of preferred securities possess a superior claim on a company’s assets and earnings in the event of liquidation or bankruptcy. They are paid before common stockholders if a company ceases operations. However, preferred securities are still subordinated to a company’s bondholders and other debt obligations.

Preferred securities generally lack voting rights. This means preferred shareholders do not participate in corporate decisions, unlike common stockholders who typically vote on corporate matters. This trade-off for a more stable income stream and priority claim means preferred shareholders forgo direct influence over company management or strategic direction.

Many preferred securities are perpetual, meaning they do not have a stated maturity date, similar to common stock. However, some preferred securities may be callable, allowing the issuing company to repurchase them under certain conditions.

Distinct Features of Preferred Securities

One significant distinction is between cumulative and non-cumulative preferred securities. If a company issues cumulative preferred stock and misses a dividend payment, that unpaid dividend accumulates. It must be paid to preferred stockholders before any dividends can be distributed to common stockholders. Conversely, with non-cumulative preferred stock, if a dividend payment is missed, it is generally lost forever and does not accrue.

Another common feature is callability, which grants the issuing company the right to repurchase the preferred shares at a specified price after a certain date. Companies may exercise this call option if interest rates decline, allowing them to issue new preferred securities at a lower dividend rate to reduce financing costs. This feature introduces reinvestment risk for the investor if their shares are called back during a period of lower prevailing rates.

Convertible preferred securities offer holders the option to exchange their preferred shares for a predetermined number of the issuing company’s common shares. This feature can appeal to investors seeking the stability of preferred dividends while retaining the potential for capital appreciation if the underlying common stock performs well. The conversion terms, including the conversion ratio and any specific dates, are outlined at the time of issuance.

Some preferred securities are structured as participating preferred, allowing holders to receive additional dividends beyond their stated fixed rate under specific conditions. These conditions might include common stock dividends exceeding a certain amount or the company achieving particular profit targets. Additionally, adjustable-rate preferred securities have dividend rates that periodically reset based on a benchmark interest rate, such as the Secured Overnight Financing Rate (SOFR). This structure can provide protection against rising interest rates for investors, as their dividend payments would increase accordingly.

Preferred Securities Versus Common Stock

A fundamental difference between preferred securities and common stock lies in their dividend characteristics. Preferred securities typically offer fixed, often cumulative, dividend payments, providing a stable and predictable income stream. Common stock dividends are variable, discretionary, and usually lower, with no guarantee of payment.

Preferred stockholders generally do not possess voting rights in corporate matters, unlike common stockholders who typically hold voting rights. This grants common stockholders direct influence over company management and strategic direction. This difference highlights the trade-off between income priority and corporate control.

In liquidation or bankruptcy, preferred stockholders have a superior claim on assets and earnings compared to common stockholders. They are paid out before common shareholders. However, both preferred and common stockholders are subordinate to bondholders.

While preferred securities offer income stability, their potential for capital appreciation is generally limited. Their prices are more influenced by interest rate movements and the issuer’s credit quality than by significant growth in the company’s share price. Conversely, common stock offers greater potential for capital appreciation as its value can increase substantially with the company’s growth and profitability. This makes common stock more appealing to investors seeking long-term growth.

Preferred securities are generally less volatile than common stock due to their fixed income component and payment priority. This makes them a more stable investment than common shares, though they carry more risk than traditional bonds. Common stock, subject to market fluctuations and company performance, typically exhibits higher volatility.

Investor Considerations for Preferred Securities

Preferred securities can be an attractive option for investors primarily seeking consistent income generation. Their fixed and often cumulative dividend payments provide a reliable cash flow, making them suitable for individuals or entities focused on regular distributions rather than significant capital growth. Many preferred issues from investment-grade companies, particularly financial institutions, contribute to a predictable income stream.

These securities can also contribute to a portfolio’s relative stability due to their lower volatility compared to common stocks. For investors aiming for a balance between the growth potential of equities and the stability of fixed income, preferred securities can serve as a middle ground, potentially smoothing overall portfolio returns.

Preferred securities can offer diversification benefits within a broader investment portfolio. Their hybrid characteristics mean they may not move in lockstep with common stocks or traditional bonds, potentially reducing overall portfolio risk.

In terms of tax treatment, dividends received from preferred securities may sometimes qualify for favorable tax rates, similar to qualified dividends from common stock. Qualified dividends are typically taxed at lower capital gains rates rather than higher ordinary income tax rates, which can enhance after-tax yields. However, investors should consult with a tax professional regarding their specific circumstances.

Preferred securities are subject to interest rate risk, meaning their value can decline when interest rates rise, similar to bonds. Credit risk, the possibility that the issuing company may default on its dividend payments or liquidation value, is also present. Additionally, callable preferred securities carry call risk, where the issuer may redeem the shares when it is financially advantageous for them, potentially leaving the investor to reinvest at lower rates.