What Is Preferred Stock? Key Features and Types

Preferred stock is a unique financial instrument blending characteristics of debt and common equity. It represents ownership, similar to common stock, but with different rights and privileges. This hybrid security offers investors stable income and a claim on company assets, typically without the same voting influence as common shares.

Key Characteristics of Preferred Stock

Preferred stock offers fixed dividend payments. These are typically a percentage of par value, paid regularly (e.g., quarterly or semi-annually), and distributed before common stockholders receive dividends. For individual U.S. investors, these dividends may qualify for favorable tax treatment as “qualified dividends,” potentially taxed at lower long-term capital gains rates, provided certain IRS holding period requirements are met.

In liquidation, preferred stockholders have a senior claim on company assets over common stockholders. They are repaid their initial investment and any accumulated unpaid dividends before common shareholders receive distributions. This claim remains junior to that of bondholders and other secured creditors.

Preferred stock generally carries limited or no voting rights. Unlike common shareholders who vote on corporate matters, preferred shareholders usually do not. This allows companies to raise capital without diluting the voting control of existing common shareholders. While some preferred shares may gain voting rights under specific circumstances, such as when dividend payments are significantly in arrears, this is not a standard feature.

Preferred stock typically does not have a maturity date. The principal investment is not repaid on a specific date, making it a permanent component of equity capital. This perpetual nature provides long-term funding for the issuing company.

How Preferred Stock Differs from Common Stock

Preferred and common stock differ significantly in dividend payment structures. Preferred stock offers fixed, often non-discretionary dividends paid before common dividends. Common stock dividends are variable and discretionary, fluctuating with profitability and board decisions, and can be suspended.

Common stock usually grants voting rights, allowing influence on corporate governance. Preferred stock generally does not confer voting rights.

In liquidation, preferred stock holds a superior claim on assets over common stock. Preferred shareholders receive their investment and accrued dividends before common shareholders. Common shareholders are residual claimants, receiving assets only after all other obligations, including preferred stock, are satisfied.

Preferred stock offers less capital appreciation potential. Its price movements are less volatile, behaving more like bonds due to fixed dividends. Common stock offers greater growth potential through share price increases as company value grows.

Preferred stock carries a lower risk profile than common stock due to its senior claim on assets and stable dividends. It sits between debt and common equity in terms of risk, offering more safety than common stock but less than traditional debt. Common stock, as the most junior security, bears the highest risk but also the highest potential reward.

Variations of Preferred Stock

Preferred stock comes in several variations, each with distinct features.

Cumulative Preferred Stock

Cumulative preferred stock stipulates that any missed dividend payments must be paid before common stockholders receive dividends. This provides protection, ensuring investors eventually receive all promised payments.

Non-Cumulative Preferred Stock

Non-cumulative preferred stock does not require the issuer to pay any missed dividends. If a dividend is skipped, it is lost, and the company is not obligated to make it up. This type of preferred stock offers less security for income-focused investors compared to its cumulative counterpart.

Convertible Preferred Stock

Convertible preferred stock provides shareholders the option to convert their shares into a fixed number of common shares at a predetermined ratio. This allows investors to benefit from common stock appreciation while retaining preferred stock’s stable income and liquidation preference. The decision to convert typically depends on the common stock’s price relative to the conversion price.

Callable Preferred Stock

Callable preferred stock grants the issuing company the right to repurchase shares from investors at a specified call price after a certain date. This benefits the issuer by allowing redemption if interest rates fall or capital restructuring is desired. The call price is usually set at the par value of the stock plus any accrued and unpaid dividends.

Adjustable-Rate Preferred Stock

Adjustable-rate preferred stock features a dividend rate that fluctuates periodically based on a benchmark interest rate, such as a Treasury bill rate or LIBOR. This protects investors from interest rate risk, as dividends adjust upward with market rates, potentially offering a more attractive yield.

Strategic Uses of Preferred Stock

Companies issue preferred stock to raise capital without diluting common shareholder voting control. This is useful for privately held companies or those maintaining ownership percentages while securing funding. It also avoids additional debt, which might impose restrictive covenants or increase debt-to-equity ratios. Preferred stock is an attractive financing option for capital-intensive projects or acquisitions, providing stable long-term capital without immediate earnings per share pressure. It offers a flexible alternative to traditional debt or common equity issuance, especially when market conditions for either are less favorable.

For investors, preferred stock is appealing due to its stable, predictable income stream from fixed dividends. This makes it suitable for income-focused portfolios, such as those of retirees or institutions seeking consistent cash flow. Its higher liquidation priority over common stock provides additional safety, making it a more conservative equity investment.