Preferred Stock

Preferred stock is a hybrid security that combines features of both equity and debt. Understanding its unique characteristics is essential for Series 7 representatives making suitable recommendations.

What is Preferred Stock?

Preferred stock is an equity security that provides shareholders with a fixed dividend and priority over common stockholders for dividends and liquidation proceeds. Unlike common stock, preferred dividends are typically stated as a fixed dollar amount or percentage of par value.

Example: A $100 par preferred stock with a 5% dividend pays $5 annually per share ($100 × 5% = $5), usually in quarterly installments of $1.25.

Preferred Stock vs. Common Stock vs. Bonds

Types of Preferred Stock

Cumulative Preferred

Cumulative preferred stock requires that any missed dividends accumulate and must be paid before common stockholders receive any dividends. These unpaid dividends are called dividends in arrears.

Example: A cumulative preferred stock pays $4 annually. If the company skips dividends for 2 years, $8 in arrears must be paid to preferred holders before any common dividends can be distributed.

Key Point: Most preferred stock is cumulative. Non-cumulative preferred is less valuable because missed dividends are permanently forfeited.

Non-Cumulative Preferred

With non-cumulative (straight) preferred, missed dividends do not accumulate. If a company skips a dividend payment, shareholders have no claim to recover it later.

Callable Preferred

Callable preferred gives the issuing corporation the right (but not obligation) to redeem the shares at a predetermined price after a specified date. Companies typically call preferred stock when interest rates fall, allowing them to reissue at a lower dividend rate.

Call price is usually at or slightly above par value. Investors face call risk—the possibility of early redemption that eliminates their income stream.

Convertible Preferred

Convertible preferred can be exchanged for a fixed number of common shares at the holder's option. This feature provides potential upside if the common stock price rises significantly.

Conversion ratio specifies how many common shares each preferred share can become.

Example: A convertible preferred with a 4:1 conversion ratio means each preferred share converts into 4 common shares. If preferred is at $100 and common is at $30, conversion yields $120 worth of common stock (4 × $30).

Parity price is when the converted value equals the preferred's market price. Above parity, conversion may be advantageous.

Participating Preferred

Participating preferred receives additional dividends beyond the stated rate if the company's earnings exceed a certain level. Shareholders "participate" in the company's success alongside common stockholders.

This type is relatively rare but offers upside potential while maintaining dividend preference.

Adjustable-Rate Preferred

Adjustable-rate (floating-rate) preferred has dividends that reset periodically based on a benchmark rate (such as Treasury rates). This helps protect against interest rate risk.

Interest Rate Sensitivity

Like bonds, preferred stock prices are inversely related to interest rates:

• Rates rise → Preferred prices fall
• Rates fall → Preferred prices rise

This occurs because preferred's fixed dividend becomes more or less attractive compared to new issues or alternative investments.

Example: A 5% preferred stock becomes less attractive if new preferred issues offer 6%, pushing its price down until its yield is competitive.

Advantages and Disadvantages

For Investors

For Issuers

On the Exam

The Series 7 exam frequently tests:

• Identifying which type of preferred stock (cumulative, callable, convertible) is described
• Calculating dividends in arrears for cumulative preferred
• Understanding the inverse relationship between preferred prices and interest rates
• Knowing the priority of claims: Bonds → Preferred → Common