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The Growing Popularity of Preferred Stocks
Appeal Tied to Dividend Priority, Low Correlation to Common Stock
 Companies that are seeking to raise money usually have two basic options: They can sell equity shares or they can borrow by issuing bonds. However, an increasing number of companies are turning to a less-used option: issuing preferred stock.
Preferred stock is becoming more popular among certain types of companies, especially banks, because it can be less expensive than issuing equity and it helps keep debt off the balance sheet.1
Investors may be attracted to “preferreds” because they are a potential source of dividend income. Preferreds also enjoy a low correlation with common stock returns, and they offer yields that are typically higher than those available from bonds, short-term debt instruments, and common stock.2
The essential difference between preferred stock and common stock is that preferreds convey additional rights to shareholders, although not all of these additional rights translate into guaranteed advantages.
First in Line for Dividends
Preferred stockholders are first in line when the company decides to issue a dividend. Preferred stocks generally offer a fixed dividend, usually a percentage of earnings, which must be paid before any dividends can be paid to common shareholders. Although the company is not generally required to pay a dividend (and may elect not to offer one when its earnings are below a certain level), some preferred shares are designated as cumulative. This means if the company fails to issue an expected dividend, the obligation to preferred shareholders accumulates and must be satisfied before the company can issue future dividends to common shareholders.
Low Volatility vs. Limited Upside
Preferred stocks tend to be less volatile than their common counterparts, but this is a sword that cuts both ways. If a company enjoys an accomplishment that causes the price of its common stock to rise, the preferred shares may not experience the same appreciation. Yet if the price of the stock falls for some reason, preferred shares are not as likely to experience a corresponding loss of value.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
Sometimes Convertible, Usually Callable
Preferred stocks that are convertible can be exchanged for a certain number of common shares according to a conversion ratio set by the issuer. A conversion might make sense if the common shares are worth more than the preferred shares for which they can be exchanged. Of course, after a conversion, the preferred shareholder is no longer entitled to preferred dividends.
Keep in mind that most preferreds are callable at the option of a company. This gives the issuer the right to buy back the shares according to terms outlined in the prospectus. Callability is among the reasons why preferred shares are sensitive to interest rates. When interest rates fall, the issuer may be able to reduce costs by calling its preferred shares and issuing new shares that better reflect market conditions.
When interest rates increase, the value of preferred shares will usually decline as a result. If rates fall, outstanding preferred shares typically become more valuable, but they are also subject to an increased call risk.
Preferred stocks have evolved in recent years as the demands of investors have changed. Call to learn more about the role that preferred stocks could play in your portfolio.
1–2) Standard & Poor’s, 2009
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