Early in your investing career, if you thought about preferred shares at all, you may have thought they were somewhat like common stock shares, but better, i. e., "preferred." But there are significant differences between these two equity classes. In fact, to avoid confusion, it might have been better not to call preferred shares "stocks" at all. In reality, they're a kind of hybrid of a stock and a bond, sharing some characteristics with each.
Common and Preferred Stock Similarities
Preferred stocks, like common stocks, are ownership shares – in both cases, when you buy the stock you've become one of the owners of the corporation. The market price of either share type rises and falls in response to the how well the corporation is doing.
Common and Preferred Stock Differences
There are probably more characteristic differences between common and preferred stocks than similarities. The biggest difference between the two share classes is that holders of common stock have voting rights, usually one vote per share. Commonly, preferred shareholders do not have voting rotes. When they do, they may offer one vote per share, like a common stock, or more votes per share (which is unusual), fewer votes per share (not uncommon). Because preferred stockholders enjoy some guarantees that common stockholders do not, another difference between the two share classes is that common stock prices are considerably more volatile than preferreds.
The dividend on a preferred share is guaranteed; the dividend on a common stock is not. In general, dividend payments on preferred shares are higher than dividend payments on common stock. Some successful companies – Amazon is one – have, as of mid-2018, never paid a common stock dividend.
The dividend for a preferred share equals the share price at issuance times the yield percentage stated in the prospectus. Because the dividend paid is a percentage of the share price on the date of issuance, the dividend itself always remains the same. A preferred share, for instance, might have a value of $100 at issuance and offer a 4 percent yield. In that case, yearly dividends always equal $4. But as the market price of the preferred share rises or falls, the dividend yield moves in the opposite direction. If, say, the market value of the preferred share rose from $100 to $110, the yield, which is calculated by dividing the dividend by the preferred share's current market value (in this instance 4 ÷ 110), drops to 3.64 percent.
The only way the dividend payment itself could change would be if the company ran into serious financial trouble and didn't have cash available to pay it (in which case, the company would still owe the full amount of the unpaid dividend and would pay it in arrears when it was able. The exception, of course, would be if the company went bankrupt.
A common stock's dividend amount, on the other hand, is determined by a vote of the corporation's board of directors. They may decide to increase the dividend, lower it, or not to issue one at all. In the event that the board decides not to issue a dividend, holders of common stock, unlike holders of preferreds, have no right for the dividend payment to be made up at some later date. Some successful companies – Amazon is one – have never paid a common stock dividend.
Why Preferred Shares Are Called "Preferred"
Another significant difference between common stocks and preferreds has to do with precedence. Since preferred shares are guaranteed, it stands to reason that paying preferred dividends takes precedence over paying common stock dividends, which are optional. But also, if the company falls on hard times and liquidates, holders of preferred shares get their money back first – their repayment rights are preferred, hence the name.
If there's enough remaining after the preferred shareholders have been fully reimbursed – that is, have been paid back the same amount per share paid at issuance including any dividend payments in arrears – common stock shareholders get what remains. But they have no guaranteed repayment right. Often, when a company liquidates, owners of common stock receive nothing.
Bond-like Characteristics of Preferreds
When you buy a bond, you expect a flow of periodic interest payments on your investment. Both the amount of each payment and the payment dates are guaranteed. The same holds true for preferred shares.
An interesting characteristic preferreds have in common with bonds is that when the economic environment shifts toward higher interest rates, preferred share prices and bond prices both decline. The reason for the decline is the same in both cases: if you have a preferred stock or a bond with a fixed interest rate – say 4 percent – when interest rates in the economy generally move upward, new bond issues and preferred issues will necessarily have higher guaranteed rates as well. The value of previously issued preferreds and bonds will decline until they've reached a point of equilibrium, where their yields are about the same as the yields on newly issued bonds and preferreds with higher interest rates.
Both bonds and preferreds may be callable, meaning that after a certain date the issuing corporation may buy them back, often at a premium. This feature, if it exists, will be clearly spelled out in the prospectus. While there are several reasons why either equity may be called, the usual reason is that the interest rate environment has declined. The corporation is better off buying back these instruments and issuing others with a lower interest rate or guaranteed dividend.
Another feature preferred shares have in common with bonds is _convertibili_ty. Many bonds and preferred shares don't have this feature. When they do, like callability, the feature will be spelled out in the prospectus. Convertible preferred shares give the holder the right, usually after a specified period of time from issuance, to convert preferreds to common shares. The conversion may be one-to-one or there may be a different fixed conversion ratio. If the common share prices rise sufficiently, it becomes worthwhile to make the conversion. Because there's no free lunch, convertible shares usually guarantee lower interest rates than a similar preferred without the feature.