Risks of Preferred Stock

Preferred stocks can provide a steady stream of predictable income.

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Each share of a company's common stock represents an equal level of ownership in the company. Some companies also offer investors a different kind of stock, called preferred stock. When you own preferred stock, you get ownership in the company, plus preferential treatment when it comes to dividends. And if the company ends up being liquidated, your claim on its assets will get priority over the claims of common stockholders. But the preferential treatment comes with its own set of risks.

Interest Rate Fluctuation

Preferred stocks typically pay a fixed dividend. This tends to make the market price of preferred stocks interest rate-sensitive, similar to bond prices in the secondary market. If prevailing interest rates drop, the market price of preferred stocks tends to rise. But if prevailing interest rates rise, preferred stock prices tend to fall.

No Dividend Guarantees

Preferred stocks are equity securities, as are common stocks. The dividend on preferred stocks must typically be paid before any dividends can be paid to common stockholders. But the dividends are not guaranteed in the same way that interest payments on the company's bonds are guaranteed. If the company misses an interest payment on its bonds, it is in default of its bond indenture, and bondholders can sue the company. If the company misses a preferred dividend payment, it's not in default

Call Provision

Some preferred stocks include a call provision, which allows the company to redeem its preferred shares on demand. A company is most likely to call its preferred stock when prevailing interest rates fall. In that situation the company could lower its expenses by redeeming the stock for its par value, then reissue it to take advantage of the lower prevailing interest rates. You'd lose the potential capital gains from rising market prices, and you'd have to reinvest your money at a potentially lower interest rate.

Liquidation Risk

If the company goes under, preferred stockholders must wait until all of the company's creditors are made whole before they have any claim on the company's assets. Bondholders get their money before preferred stockholders get theirs. Preferred stockholders come next in the pecking order, and common stockholders can divide whatever is left.