Preferred Stocks

Definition

A preferred stock is a hybrid security that sits in the middle of a company's capital structure — part bond, part stock, and not quite either. Like a bond, it pays a fixed, scheduled dividend and trades mostly on that income stream. Like common stock, it is a form of equity ownership and shows up on the equity side of the balance sheet. Income investors buy preferreds for one reason above all: a steady, relatively high, contractually defined payout.

The word "preferred" refers to where these shares stand in line. If a company runs into trouble and has to pay out what it owes, the order of priority is:

Highest priority (paid first)
  1. Bondholders and other lenders
  2. Preferred shareholders
  3. Common shareholders
Lowest priority (paid last)

So preferred shareholders rank below bondholders but above common shareholders for both dividends and any claim on assets in a bankruptcy. A company must pay its preferred dividend in full before it can pay a single cent to common stockholders — that seniority is the "preference."

A few features define almost every preferred:

• Fixed dividend. The payout is set when the share is issued — for example, a "6.00%

Series A Preferred." That rate is quoted against a par value, which for exchange-listed preferreds is almost always $25 per share. A 6% coupon on $25 par pays $1.50 a year, usually in four quarterly installments.

• No voting rights (usually). Preferred shareholders generally give up the vote that

common shareholders have. In exchange they get their senior, fixed income.

• Often callable. Most preferreds are callable, meaning the issuer can buy them back

at par (typically $25) after a set date. This matters a great deal — see call risk below.

• Perpetual or long-dated. Many preferreds have no maturity date at all; they can pay

their fixed dividend indefinitely until called.

Why It Matters

Preferred stocks matter to income investors because they occupy a genuinely different spot on the risk-and-income spectrum than either common dividend stocks or bonds. They typically yield more than the same company's bonds (compensation for standing lower in line) and more than most common dividend stocks, while offering a payout that is contractually senior to common dividends. For an investor who wants income first and price appreciation second, that combination is the appeal.

The trade-off is that you give up most of the upside. A preferred's price is anchored to its fixed payout, so it does not climb the way a growing company's common stock can. You are buying an income stream, not a growth story. In a strong bull market, preferreds lag common shares badly; in a downturn, they usually hold up better than common but can still fall hard if credit fears rise or interest rates jump.

That last point is the one investors most often miss: preferreds behave like bonds. Because the dividend is fixed, the price moves inversely to interest rates. When rates rise, a preferred paying a fixed 6% becomes less attractive than newly issued 7% paper, so its price falls until its yield is competitive. When rates fall, the opposite happens and prices rise. A preferred's day-to-day price is driven far more by the direction of interest rates and the issuer's credit quality than by the company's earnings growth. Sizing that interest-rate sensitivity correctly is the whole game.

There is also a tax angle that tilts the math in the preferred's favor for taxable accounts: many preferred dividends are qualified dividends, taxed at the lower long-term capital-gains rate, whereas the interest from a bond is taxed as ordinary income. Two securities can advertise the same headline yield, and the preferred can leave you with more after tax. (Not all preferreds qualify — notably, those issued by REITs generally do not — so confirm before assuming.)

Cumulative, Callable, and Floating: The Features That Matter

Preferreds come in several flavors, and the fine print changes the risk meaningfully.

Cumulative vs. non-cumulative. If a company skips a preferred dividend, what happens to the missed payment?

• A cumulative preferred keeps a running tab. Any skipped dividends accrue and must be paid

in full — all the arrears — before common shareholders receive anything. This is the more investor-friendly structure.

• A non-cumulative preferred does not. A skipped dividend is simply gone; the issuer never

has to make it up. Bank preferreds are frequently non-cumulative because regulators prefer it, so read the terms.

Fixed-rate vs. fixed-to-floating. A plain fixed-rate preferred pays the same coupon for its entire life. A fixed-to-floating (sometimes "fixed-to-float") preferred pays a fixed rate for an initial period — often five years — and then, if not called, switches to a floating rate tied to a benchmark plus a spread. Floating structures give some protection if interest rates rise after issuance, because the coupon can reset higher, but they add complexity and uncertainty about your future income.

Call risk. Because most preferreds are callable at $25 par after a set date, the issuer holds an option you effectively sold them. If rates fall or the company's credit improves, it can call your 6% preferred and reissue cheaper — right when you would most want to keep the high payout. The practical effects:

• A preferred trading above par (say $27 on a $25 par) can be called away at $25, handing you

a capital loss. Never chase a rich-looking yield without checking the call date and price.

• Call risk caps your upside. A preferred rarely trades far above par for long, because everyone

knows it can be redeemed at $25.

Rule of thumb: for a callable preferred trading above par, look at the yield to call, not just the current yield. The stated yield can be a mirage if the issuer is likely to redeem the shares at $25 well before you collect it.

Example

Suppose a company issues a 6.00% Series A Preferred at a $25 par value, callable in five years. It pays $1.50 a year — $0.375 each quarter. At issue, the yield is exactly 6% because it trades at par.

Now watch what interest rates do to it. The numbers below are illustrative:

• Rates rise. New preferreds of similar quality come to market at 7%. Investors will not pay

$25 for a 6% payout when they can get 7% elsewhere, so the price drifts down to around $21.40, where the $1.50 dividend works out to roughly a 7% current yield. You still collect $1.50 a year, but the share is worth less on paper — classic bond-like behavior.

• Rates fall. New comparable preferreds yield 5%. Now the 6% payout looks generous, and the

price rises toward $25 — but no higher, because the company can simply call the shares at $25 par once the call date passes and reissue at 5%. That call ceiling is why preferreds rarely soar.

Here is how a preferred stacks up against the same company's common stock and its bonds:

Read across the "Preferred Stock" column and you can see the hybrid clearly: bond-like fixed income and seniority over common, but the qualified-dividend tax treatment and equity label of a stock — with call risk as the distinctive extra hazard.

Preferred ETFs vs. Individual Issues

Most income investors get their preferred exposure through a preferred ETF rather than by hand-picking individual issues, and for good reason. A single preferred concentrates you in one issuer's credit; if that company falters, your income and principal are both at risk. Buying individual preferreds well also requires reading each prospectus for the call date, cumulative status, and floating terms — real work.

A preferred ETF spreads that risk across hundreds of issues and handles the homework for you:

• PFF — the largest, broadly diversified preferred index fund,

a common one-ticket way to own the market.

• PGX — another large, index-based preferred fund with a similar

broad-market profile.

• PFFA — an actively managed preferred fund that can use

leverage to lift its payout, which raises both the yield and the risk.

The trade-offs run both ways. An ETF gives you instant diversification, monthly income, and liquidity, but you pay an expense ratio and you cannot control the call exposure or lock in a specific yield to call. Buying individual preferreds lets you target a known yield to call and a specific credit, but demands more research and more capital to diversify properly. For most people building an income sleeve, a low-cost, diversified preferred ETF is the more sensible starting point.

Common Mistakes

• Ignoring interest-rate risk. Preferreds are bond-like. If you buy them for the yield and

are surprised when the price drops after a rate hike, you have misunderstood the security. Treat a preferred's price sensitivity to rates as its defining risk.

• Chasing yield without checking the call. A preferred trading above par can be called at $25,

turning an attractive current yield into a capital loss. Always look at the yield to call and the call date before buying a preferred priced above par.

• Assuming every preferred is cumulative. Non-cumulative preferreds — common among banks — let

the issuer skip a dividend for good, with no obligation to make it up. Confirm the cumulative status in the terms.

• Overlooking the qualified-dividend detail. Many preferred dividends are

qualified and taxed at the lower rate, but preferreds from REITs and some other structures are not. Do not assume; the tax treatment can swing the after-tax yield noticeably.

• Treating preferreds like a growth investment. Preferreds are for income and relative

stability, not appreciation. Their upside is capped near par by the call feature. If you want growth, that is the job of common stock, not preferreds.

FAQ

Are preferred stock dividends qualified?

Often, yes — but not always. Many preferred dividends from ordinary U.S. corporations meet the requirements for qualified dividends, which are taxed at the lower long-term capital-gains rate rather than as ordinary income. That is a meaningful advantage over bond interest, which is always taxed as ordinary income. The big exceptions are preferreds issued by REITs and certain other pass-through structures, whose distributions are generally not qualified. Because it varies by issuer, check the fund or company's tax documentation (the 1099-DIV breaks out qualified versus ordinary) before assuming the favorable rate applies.

Are preferred stocks a good income investment?

They can be, for the right investor. Preferreds typically offer a higher, more stable yield than common dividend stocks, seniority over common shares, and often favorable tax treatment. That makes them a reasonable building block for an income-focused portfolio. But they are not a free lunch: their prices fall when interest rates rise, they carry the issuer's credit risk, and callable issues can be redeemed just when you want to keep them. Whether they fit depends on your need for income versus growth and your tolerance for interest-rate swings. This is educational information, not a recommendation to buy or sell any security.

How are preferred stocks different from bonds?

Both pay a fixed income and both are sensitive to interest rates, but a bond is debt and a preferred is equity. Bondholders rank ahead of preferred shareholders if a company fails, and bonds usually have a fixed maturity date at which principal is repaid, while many preferreds are perpetual. Bond interest is taxed as ordinary income; many preferred dividends are qualified and taxed at a lower rate. In short, preferreds trade a slightly weaker claim and no maturity for a higher yield and often better tax treatment.

What does callable mean for a preferred stock?

Callable means the issuer has the right to buy the shares back at the par value (usually $25) after a set call date. Companies call preferreds when it is advantageous to them — typically after interest rates fall or their credit improves — so they can reissue at a lower cost. For you, a call caps the upside and can force a loss if you paid more than $25. This is why investors look at the yield to call on any preferred trading above par, rather than the current yield alone.

What is the difference between cumulative and non-cumulative preferreds?

If a company skips a dividend, a cumulative preferred requires it to pay all the missed payments later, in full, before common shareholders get anything — the skipped income accrues. A non-cumulative preferred imposes no such obligation: a skipped dividend is simply lost forever. Cumulative terms are more protective for the investor, so they matter especially with issuers, like banks, that may suspend payments in a downturn.

Should I buy a preferred ETF or individual preferred stocks?

A preferred ETF such as PFF or PGX spreads your money across hundreds of issues, pays monthly, and handles the prospectus-level homework — the simpler choice for most investors. Buying individual preferreds lets you target a specific yield to call and a specific issuer's credit, but it demands more research and enough capital to diversify, and it concentrates your risk in single companies. For a first income sleeve, a diversified, low-cost preferred ETF is usually the more practical route. Either way, this is educational information, not investment advice.