Most preferred stocks pay fixed dividends guaranteed by the terms under which the shares are issued. Preferred stock is sometimes labeled a “hybrid” security, because it combines ownership like common stock with regular income like a bond. If you are an income-seeking investor, you may find preferred shares to be an attractive alternative to bonds.
Dividends on preferred stock are generally greater than you get from most common stocks. When a company issues preferred shares, it guarantees it will pay a fixed dividend if at all possible. Companies are thus contractually obligated to pay preferred dividends before any dividends on common stock can be paid. In addition, should a company be liquidated, preferred shareholders are paid off before common stock owners, although they wait in line behind the bondholders. These features mean that preferred shares have lower investment risk compared to common stock.
A business downturn or financial problem can force a company to skip a preferred stock dividend. For this reason, many companies issue cumulative preferred stock to protect investors. “Cumulative” means that any missed dividend payments must be paid when business conditions permit. In addition, all dividends in arrears must be paid before any dividends on common stock can be paid.
Another option for investors is participatory preferred stock. Issues with this feature pay an additional dividend over and above the guaranteed fixed amount if the company meets specified goals such as improved sales or earnings. There are also some preferred stocks that pay an adjustable rate. With adjustable preferred the dividend rate is variable, rather than fixed. Changes in the rate are usually keyed on a market rate such as the Treasury T-bill interest rate.
Because preferred stocks pay fixed dividends comparable to the interest you earn from bonds, they tend to behave much like bonds. That is, when market interest rates go up, the rates paid by existing preferred shares are less attractive to investors. Demand falls, and the price tends to drop. If interest rates drop, the higher rates paid by existing preferred stocks generate increased investor demand. That, in turn, tends to drive the share price up.