Preferred stock has characteristics of both common stock and the long-term bonds corporations sell to borrow money. For this reason, preferred stock is often referred to as a hybrid of common stock and bonds. This dual nature makes preferred stock an alternative investment option worth considering if you are looking for income-producing investments but don’t want to limit yourself to only buying bonds
Corporations can sell both preferred stock and long-term bonds to raise money instead of issuing more shares of common stock. One reason companies do this is that these securities don’t dilute the voting strength of existing stockholders. Preferred shares do give you an ownership interest, but you generally don’t have voting rights at stockholders’ meetings. Long-term bonds are debt securities, usually with maturities of five to 30 years. When a bond matures, it must be paid off like any other debt. As an equity security, a preferred stock doesn’t have to be repaid and thus has an indefinite lifespan. Companies may issue several types of preferred stock and bonds, each with specific features. For example, the terms for both preferred shares and bonds might include the option of conversion to common stock.
One feature of preferred stocks and long-term bonds that attracts investors is that both offer current income. With preferred shares, the income is in the form of a fixed dividend whose amount is stated in the stock’s prospectus. Bonds pay a fixed amount of interest each year. The yields of bonds and preferred shares are typically comparable to one another. However, some preferred stocks are participatory, meaning that if the company meets earnings criteria stated in the prospectus, the dividend may be increased. One downside to preferred stocks is that the company can stop paying the dividend if it runs into financial trouble. It cannot stop paying the interest payments to bondholders.
Preferred shares carry less risk than common stock, although somewhat more than bonds. In the event a company becomes insolvent, bond holders are paid off before any stockholders receive money. Preferred shareholders are paid next and common stock shareholders come last. Bond interest payments must be paid first, before any dividends are paid. However, a company is obligated to pay preferred stock dividends if at all possible and must pay them before paying any dividends to common stock shareholders. Some preferred stock is cumulative, which means missed dividends must be paid when the company’s financial condition permits.
As a preferred stock trades in the stock market, its price behavior resembles that of long-term bonds. Investors who buy either security are typically seeking current income, so they look for the best interest or dividend yields available. If prevailing interest rates change, the prices of both preferred shares and bonds respond accordingly. Suppose interest rates go down. The yield, or effective interest rate, of existing bonds and preferred shares is then higher than the new market rates, and this increases investor demand. Investors bid up the prices of bonds and preferred stocks. The reverse happens if interest rates rise. The yields of existing preferred stocks and bonds are then less attractive and investor demand falls off, so the prices of both securities tend to drop.