Preferred Stock: A Balanced Investment Between Bonds and Common Shares

Preferred stock is a unique type of equity security that blends characteristics of both common stock and bonds. Unlike common stock, which represents ownership with voting rights and variable dividends, preferred stock typically offers fixed dividend payments and a higher claim on a company’s assets in the event of liquidation. However, preferred shareholders usually do not have voting rights, making preferred stock a hybrid investment that appeals to income-focused investors who want more stability than common shares but potentially higher returns than bonds.

Understanding Preferred Stock Dividends and Priority

One of the defining features of preferred stock is its fixed dividend. These dividends are generally expressed as a percentage of the stock’s par value, which is the original value assigned to the share. For example, if a preferred stock has a par value of $100 and an annual dividend rate of 5%, the dividend paid to shareholders would be $5 per share annually. This can be represented by the formula:

Dividend = Par Value x Dividend Rate

Dividend = $100 x 5% = $5 per share annually

These fixed dividends are paid before any dividends are distributed to common shareholders. Moreover, in the event a company faces bankruptcy or liquidation, preferred stockholders have a higher claim on assets than common stockholders but rank below debt holders. This priority reduces the risk relative to common stock but is higher risk compared to bonds.

Real-Life Example: Bank of America Preferred Shares

A practical example comes from Bank of America (ticker symbol: BAC), which issues several series of preferred shares. Suppose an investor buys BAC preferred stock with a fixed dividend yield of approximately 6%. This yield might be higher than the dividend yield on BAC’s common stock, reflecting the fixed income nature and priority in dividend payments. However, the investor does not have voting rights in Bank of America’s shareholder meetings, differentiating it from common shares.

Common Misconceptions About Preferred Stock

One common misunderstanding is that preferred stock behaves exactly like bonds. While preferred shares offer fixed dividends similar to bond coupon payments, they are still equity instruments. This means the company can technically suspend preferred dividends without forcing bankruptcy, unlike bond interest payments, which are legally binding obligations.

Another misconception is that preferred stock is always less risky than common stock. While it is generally safer due to dividend priority and higher claim in bankruptcy, preferred stock can still be volatile, especially when interest rates fluctuate. Because preferred dividends are fixed, an increase in interest rates can make preferred shares less attractive, causing their market price to fall.

People also often ask: “Do preferred shareholders have voting rights?” The answer is generally no. Preferred stockholders typically do not vote on company matters, which means they have less influence over management decisions compared to common shareholders.

Related Queries and Considerations

Investors frequently wonder how preferred stock fits into a broader portfolio. Preferred stock can be part of an income-focused strategy, offering more predictable dividends than common stock. However, investors should be aware of interest rate risk, dividend suspension risk, and the lack of voting power.

Another related question is: “How is preferred stock taxed?” Dividends from preferred stock are usually taxed as ordinary income, but in some jurisdictions, qualified dividends may receive favorable tax treatment. It’s important to understand local tax laws when investing in preferred shares.

In summary, preferred stock is an equity instrument that offers fixed dividends and priority in payouts but usually without voting rights. It is suitable for investors seeking a middle ground between the stability of bonds and the growth potential of common shares. As always, understanding the specific terms and risks associated with any preferred stock issue is crucial before investing.