Why Is Preferred Stock Often Referred to As the Hybrid of Common Stock & Debt?

Investors usually look for equity growth, income or a combination of the two. If you are trying to grow the value of your portfolio, odds are good you’ll include a selection of common stocks. Conversely, if you want current income you are more likely to invest in interest-bearing debt securities like bonds. Preferred stock is often referred to as a hybrid because preferred shares share characteristics of both common stock and the debt represented by bonds.

Description

A preferred stock is an equity security whose dividend is stated as part of the terms and conditions in the stock prospectus. Unlike common shares, preferred shares are usually nonvoting. This means preferred shareholders cannot vote at stockholders' meetings. A company may issue several types of preferred stock, each with different features. Unlike a bond, a preferred stock does represent an ownership share in the company and is not a debt that has to be repaid.

Income

The dividend a preferred stock pays is fixed, as is the interest amount a bond pays. The percentage rate of the dividend is usually higher than common stock dividends and often compares favorably with bond interest rates. Thus, an investor seeking to generate current income can use preferred stock as an alternative to bonds. Some preferred stock is participatory, meaning that additional dividends may be paid if the company does well and meets criteria stated in the stock prospectus.

Risk

The investment risk of preferred shares is less than you accept when you invest in common stock, but somewhat higher than for bonds. If a company is liquidated, bondholders and other creditors are paid first. Preferred shareholders must be paid next, before any distribution of company assets is made to common stock shareholders. A company must pay the agreed dividend on preferred shares if at all possible and before any common stock dividends are paid. However, interest on bonds must be paid first. And the failure to pay a preferred stock dividend does not send the company into default, as the failure to pay bond interest would. Some preferred stocks accumulate any missed dividends, which means the preferred shareholders must be paid a current dividend as well as all missed dividends before the common stockholders get another dividend payment.

Price Behavior

The manner in which preferred stock prices fluctuate is very similar to what you see for bonds. This is because investors view preferred stock as an income security like bonds. When market interest rates increase, interest-bearing securities paying the higher rates are more attractive to investors than existing bonds or preferred shares. Demand falls off and the price tends to drop until the effective yield is again competitive. If interest rates go down, the reverse happens. Demand for higher-paying preferred shares and bonds increases, driving prices up.