What you need to know about preferred stock?

Preferred stock, also know as preferred or preference shares is one of the main types of stock besides common shares. It is considered that preferred stock is a hybrid security that combines properties of debt (fixed dividends) and equity (potential to raise in price). They are distinct from common shares because they don’t have voting rights but have higher claim on company’s assets and earnings. Terms of preferred stock are described in issuing document; they can be issued under any set of terms that is compliant to laws and regulations.

Preference in dividends is what distinguish preferred from common stock. Board of directors makes decision whether or not company will pay dividends to its shareholders. Dividends are specified as percentage of the par value or as a fixed amount. Common shareholders can receive dividends only if preferred shareholders are already paid in full if board decides to pay them dividends in the first place. This makes them similar to bonds but they don’t have same level of guarantees. If company is not operating well and choose not to pay dividends it is not in default. Almost all dividends are fixed but they can be set in terms of a benchmark interest rate. This means that preferred stock offers more predictable income and they are rated by major credit agencies. In comparison to bonds credit ratings are lower because guarantees for preference shares are lower. One more difference is that preferred dividends are payed after tax profits and bonds are paid before.

Dividend payments makes preferred shares less risky than common stock suitable for risk-averse investors. Although many individual investors purchase preference shares via online brokers, institutions are the most common purchaser because certain tax advantages offered to them. In case of bankruptcy they have higher senior position to common shareholders but junior to bondholders. Being less sensitive to company loss they trade within few dollars of the issue price which makes them non volatile type of security. On the other hand preferred shareholders will not participate in company success like common stockholders.

Although preferred shareholder don’t have voting rights some companies can use them against hostile takeover through shareholders right plan giving shareholders right to buy shares at a discount if one shareholder buys certain percentage of shares, diluting his ownership. They can also assign high liquidation value to preferred stock which must be redeemed in the event of change of control. Callability is another characteristic of preferred shares, meaning that the issuer can purchase them back after a certain date at stated value. If company decides not to exercise this option shares can continue to trade. They are also convertible, they can be exchanged for a set number of common shares under certain circumstances but not vice versa. Whether this is profitable or not for an investors depends on the current price of common shares.

When it comes to dividends there are more than one type of preferred stock. Cumulative dividends enables shareholder to receive all missed dividend payments. Only after all dividends in arrears are payed to preferred shareholders, common stockholders can be paid. Non-cumulative preference shares don’t have the same option, they will not accumulate if they are not paid on time. Participating preferred stock offers stockholder opportunity to receive extra dividends based on predetermined conditions.

Investor should carefully take into consideration both advantages and disadvantages when looking to invest. If you are looking to relatively low risk investment you should consider preferred stock. In case you have any doubts our consultants will be glad to answer your questions.

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