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What is a preferred stock?

Introduction

Certain corporations in the U.S. have two classes of stock: common stock and preferred stock. A preferred stock is a class of ownership in a corporation that has a higher claim on its assets than common stock in the event of a bankruptcy or liquidation. Preferred stock is still considered to be "equity" in that claims of preferred stockholders are secondary to any claims of creditors.

What makes preferred stocks unique is that most preferred stocks are designed to pay regular dividends. Preferred shares usually are issued with a fixed, predetermined dividend rate, although sometimes they are issued with a dividend rate that can vary based on a interest rate benchmark such as the 3-month LIBOR. There is no guarantee of course that a company will be able to make its dividend payments on preferred stock, but unless a company gets into financial trouble, most companies pay out the dividends on the preferred stock on a regular basis, usually every quarter. Preferred shares generally have a dividend that must be paid out before the company can pay any dividends to common shareholders.

Preferred shares may or may not come with any voting rights. You have to look carefully at the prospectus to determine what shareholder rights a preferred stock holder has.

Preferred stocks are not that common. Most U.S. corporations that are publicly traded on the stock market have only common stock. See our list of preferred stocks. that are traded on U.S. stock exchanges.

Preferred stock is very much a "hybrid" security that acts somewhat like a bond and somewhat like a common stock. Generally the market price of a preferred stock does not vary as much as a company's common stock. Preferred stocks can be more volatile than a bond, especially when the company is going through significant market stress or during periods of a stock market crash. If the stock market is relatively stable and there is nothing major going on with the company, preferred stocks tend to act like a bond, in the sense that they tend to go up or down in response to changing interest rates. But during a stock market crash, a preferred stock can often act more like a common stock than a bond.

How are they designed?

Almost all preferred stocks are issued with a "liquidation value" and a pre-determined dividend rate that together determine the total dividends on the stock. When issued, the preferred stock will also specify exactly when the dividend payments will be made (i.e. monthly, quarterly, etc...). Once issued, the terms of a preferred stock don't change. For example, a preferred stock that is issued with a set dividend rate of 5% would pay 5% of the liquidation value, which is usually $25 per share. Liquidation value is used to determine the actual dividends per share on a preferred stock but it is also important because it is the stated value per share in the event of a company liquidation, as a way to determine the priority of claims of creditors versus stock holders.

There is no rule that requires it, but the tradition has become that most preferred stocks have a $25 liquidation value. That makes it easy to tell if the stock is trading at a discount or premium, because you can just compare the current market price to $25.00.

Dividend periods

Most preferred stock pays out their dividends on a quarterly basis.

Perpetual preferred stock

Most preferred stock is "perpetual", which means that it remains outstanding forever (i.e. there is no maturity date).

But the fact that most preferred stocks are perpetual is a little misleading. Most preferred stock is "callable" by the issuer - i.e. it can be redeemed by the company, at the company's option, typically after they give investors a 30 day or 60 day advanced notice. Most preferred stock cannot be redeemed right away (immediately after issuance). Typically, preferred stock is callable only after it has been on the market for a few years. Preferred stock is redeemed or called quite often before maturity, for all number of reasons. For example, if interest rates fall, the company may call its preferred shares and issue another series with a lower yield. Shares can continue to trade past their call date if the company does not exercise this option.

Because of the call features, preferred stocks are being issued and redeemed all the time, partly in response to changing interest rates, but also as companies manage their capital positions

Cumulative preferred stock

Some preferred stock is "cumulative" preferred stock, meaning that if the company misses a scheduled dividend payment on the preferred stock, the dividends owed must be paid out in the future before common stock shareholders can receive any dividend payments. And if the company ever tries to redeem or call the preferred stock, they have to redeem the stock at price that includes the missed dividends. So preferred stock that is cumulative starts to act almost like debt, because the company is required to accrue and/or pay the dividends.

Convertible preferred stock

Some preferred stock is convertible, meaning it can be exchanged for a given number of common shares under certain circumstances. The board of directors might vote to convert the stock, the investor might have the option to convert, or the stock might have a specified date at which it automatically converts.

Convertible preferred stock is much more difficult to analyze because it usually contains a complex formula to determine the conversion ratio between the preferred stock and the common stock. It often isn't easy to understand whether it is a good deal or a bad deal to convert the preferred stock into common stock. Because the value of convertible preferred stock is tied to the value of the company's common stock, you often find that convertible preferred stock trades at a much greater discount or premium to par value compared to non-convertible preferred stock.

Issuing entities

There are a lot of preferred stocks issued by BDCs, closed end funds, MLPs, mortgage REITs and REITs. That makes sense because these types of entities are yield focused entities - many investors buy these entity types because they are looking for a high dividend yield. Issuing preferred stock is one way that these entities can attempt to boost their dividend yield to common stockholders, in essence using a form of leverage.

Most of the "common stock" issuers are banks and other financial institutions.

Preferred stock ADRs

It is very common for preferred stock to be trading in the form of an American Depository Receipt, or "ADR". Most people think of an ADR as the common stock of a foreign corporation that is trading on a U.S. stock exchange as an ADR, as explained in our article what is an ADR?. But a lot of preferred stock is issued by American corporations via the same ADR process.

Why are so many preferred stocks issued as ADRs? We don't really know. It could be because companies want to issue their preferred stock at a $25 liquidation or par value, as explained above. An ADR can be issued with a "ratio" between the ADR and the actual security that is not equal to one. In other words, you can issue an ADR that is worth 25 shares of the actual stock. So if a company has a preferred stock with a liquidation value of $250, they can issue an ADR with a one to 10 ratio, thus creating a preferred stock that trades with a $25 liquidation value.

What is par value?

It can be confusing with preferred stocks to separate a "par value" from a "liquidation value". What exactly is par value versus liquidation value? The concept of par value was originally an accounting concept. It is the value that determines how much of the proceeds from the issuance of a stock gets recorded as "common stock" or "preferred stock" on a company's balance sheet versus "additional paid in capital". A lot of preferred stock gets issued with a par value of $.01 per share. But it has a liquidation value of $25.00 per share.

In day to day practice, however, many people refer to the $25 liquidation value of a preferred stock as simply the "par value", even though technically the par value might be $.01 per share. It's a loose way of referring to what really matters, which is the liquidation value.

Preferred stock symbols

Preferred stocks are often a pain because they have ticker symbols that can vary from website to website. Some preferred stocks have "normal" symbols such as "AIZP" that are universally referenced the same way. But many companies issue several different series of preferred stocks (series A, series B, etc...) and thus try to start using special preferred stock symbols with a series designator. That's what creates the confusion, as not all websites handle the series reference the same way.

ETFs that buy preferred stock

There are now 17 ETFs and ETNs that either buy preferred stock or track an index of preferred stock:

Name	Symbol	Last price	Currency
Global X US Preferred	ARCX:PFFD	19.76	USD
VanEck Vect Preferred Securities ex Fina	ARCX:PFXF	17.71	USD
Virtus InfraCap U.S. Preferred Stock	ARCX:PFFA	22.03	USD
AAM LOW DUR PREF & INC SEC	ARCX:PFLD	20.73	USD
PRNCPAL SPCTRM PREF SEC ACTV	ARCX:PREF	18.65	USD
American Century ETF Trust American Century Quality Preferred ETF	BATS:QPFF	36.16	USD
Global X SuperIncome Preferred ETF	ARCX:SPFF	9.39	USD
INFRACAP REIT PREFERRED ETF	ARCX:PFFR	18.68	USD
iShares US Preferred Stock	XNAS:PFF	31.65	USD
Invesco Preferred ETF	XNYS:PGX	11.64	USD
Invesco Financial Preferred ETF	XNYS:PGF	14.75	USD
ETRACS 2xMonthly Pay Leveraged Preferred Stock Index ETN	ARCX:PFFL	9.33	USD
Invesco Variable Rate Preferred ETF	XNYS:VRP	24.32	USD
Global X Variable Rate Preferred ETF	ARCX:PFFV	23.84	USD
SPDR Wells Fargo Preferred Stock ETF	ARCX:PSK	33.31	USD
John Hancock Exchange-Traded Fund Trust John Hancock Preferred Income ETF	ARCX:JHPI	22.85	USD
Innovator S&P Investment Grade Preferred ETF	BATS:EPRF	18.50	USD