Preferred stocks are dividend-paying investments that are quite different from their common-stock cousins. If you buy a preferred stock when first issued you're essentially loaning money to a company in exchange for regular dividend payments. Most preferred stocks, but not all, have a set maturity date at which you'll receive a return of your principal. Many preferred stocks also have a call date, at which time the issuing company can buy the stock back from investors.
A call date is somewhat akin to a maturity date, except it is an optional one. Further, the option lies only with the issuing company, not with you as a shareholder. Whereas your preferred stock has a mandatory payoff provision at maturity, when a call date arrives, the issuing company gets to decide if it wants to pay you off or not. A company will announce in advance whether or not it's going to take advantage of the call provision, but typically only within a few months, not a few years. Some preferred stocks have multiple call dates. If one passes, the company still has the option to pay off the preferred at any of the subsequent call dates.
Effect on Profit Potential
One of the main consequences of owning a preferred stock with a call date is that your profit potential is limited. While preferred stock prices tend to go up when interest rates fall, falling interest rates also make it more likely that an issuer will call the preferred. By paying off a preferred when interest rates are lower, a company can reissue a new preferred at a lower interest rate, thereby saving it money. Since most preferred stocks are called at par value, or the price at which the preferred was originally issued, it's unlikely that your preferred will trade much above par value, even when market interest rates fall.
The higher the interest rate on your preferred stock, the more likely you'll lose it before maturity if it has a call date. No company wants to pay more interest than it has to, so as soon as interest rates go down, your preferred stock will get called away at the earliest opportunity. As an investor, this is problematic because it means you'll be receiving your principal back at a time when other available investments are paying a low rate of interest. You'll end up earning less money on your principal than if you were able to hold your preferred stock all the way until maturity.
If your preferred stock gets called, in the eyes of the Internal Revenue Service it's the same as if you sold the stock yourself. You'll have to report the trade when you file your taxes, and you may owe capital gains tax if you receive more than you originally paid for the stock. If the stock is called at a lower price than you paid, you'll be forced to take the loss. While you may be able to use this loss to offset other taxable gains, it's generally preferable to decide for yourself when you want to book a loss, rather than having a call date determine the timing.
John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.