Preferred Stock
Definition
Preferred stock is a class of ownership that pays a fixed dividend and ranks ahead of common stock for dividends and liquidation proceeds, usually in exchange for giving up voting rights.
Detailed Explanation
Preferred stock is a hybrid, and the name explains exactly one thing about it: preference in line. Preferred shareholders get paid their dividend before common shareholders get anything, and if the company is liquidated, they're paid before common holders — though still behind every bondholder and creditor. That's the entire meaning of "preferred." It doesn't mean better, and it doesn't mean safer than debt.
Functionally the security behaves much more like a bond than like equity. The dividend is a fixed rate on a par value, typically $25 per share for retail-oriented issues, and it doesn't grow when the company prospers. That's the central trade: a common shareholder participates in growth, while a preferred shareholder gets a defined payment and stops there. Preferred shares are typically perpetual, with no maturity date, and they're priced off yield — so when interest rates rise, existing preferreds fall, exactly as bonds do. Most issues also come from a narrow slice of the market: banks, insurers, and REITs dominate issuance, so a portfolio of preferreds carries real sector concentration.
Several features change the risk meaningfully, and they're specified in the prospectus rather than being standard. Cumulative preferreds require any skipped dividends to be paid in full before common shareholders receive anything; non-cumulative ones don't, and a missed payment is simply gone. Callable issues let the company redeem shares at a set price after a set date — which it will do when rates fall, precisely when you'd most want to keep the income. Convertible preferreds can be exchanged for a set number of common shares, adding upside. For callable issues, yield-to-call matters more than the headline yield.
The tax treatment is where preferreds surprise people. Many preferred dividends are qualified and taxed at long-term capital gains rates, but a substantial share are not. REIT preferreds generally pay non-qualified dividends taxed as ordinary income, and bank-issued trust preferred securities are often treated as interest rather than dividends. Two preferreds with identical stated yields can deliver very different after-tax income depending on the issuer's structure, which is why the offering documents and your Form 1099-DIV matter more here than with ordinary dividend investing.
Example
Suppose a bank issues preferred shares at a $25 par value paying a 6% annual dividend — $1.50 per share each year, fixed. If the bank's business doubles and the common stock triples, the preferred still pays $1.50; the shares may drift up modestly but won't track the common. If interest rates rise sharply and comparable new issues yield 8%, the existing shares fall toward roughly $18.75 so their $1.50 payment matches the market rate. And if rates instead fall to 4%, the bank will likely call the shares at $25, ending the income stream just as it became most valuable.
Key Articles Related To Preferred Stock
Related Terms
Common Stock: The standard class of ownership, carrying voting rights and unlimited upside but ranking last for dividends and in liquidation.
Dividend: A distribution of company earnings to shareholders, fixed and prioritized in the case of preferred stock.
Fixed-Income Investment: An investment paying a set schedule of income, the category preferred stock most closely resembles in behavior.
Par Value: The face value a preferred share's dividend rate is calculated from, and typically the price at which it can be called.
Callable: A feature allowing the issuer to redeem shares at a preset price after a specified date, capping the investor's upside.
FAQs
What's the difference between preferred stock and common stock?
Preferred pays a fixed dividend and gets paid before common in both dividends and liquidation, but usually carries no voting rights and doesn't participate in the company's growth. Common has voting rights and unlimited upside but sits last in line.
Is preferred stock safer than common stock?
It ranks higher in the capital structure, so it's more protected in a liquidation and its dividend is more reliable. But it sits behind all debt, and its price is exposed to interest rate moves in a way common stock isn't. Safer in one dimension, differently risky in another.
Is preferred stock a bond?
No, though it behaves like one. It's equity, so its dividends must be declared by the board rather than being a contractual obligation, and skipping them isn't a default the way missing a bond payment would be. In bankruptcy, bondholders are paid first.
How are preferred dividends taxed?
It depends on the issuer. Many preferred dividends are qualified and taxed at long-term capital gains rates. REIT preferreds typically pay non-qualified dividends taxed as ordinary income, and bank trust preferred securities are often treated as interest. Check the offering documents and your 1099-DIV rather than assuming.
What does callable mean, and why does it matter?
The issuer can buy the shares back at a set price after a set date. Companies call when rates have fallen and they can refinance more cheaply — meaning your income ends at the worst possible moment for you. For callable issues, calculate yield-to-call, not just current yield.
Should individual investors own preferred stock?
It's a niche income holding, not a core position. The sector concentration in banks, insurers, and REITs, plus interest rate sensitivity and call risk, make it more complicated than it looks. Investors who want it commonly use a preferred stock ETF for diversification rather than picking individual issues.