Preferred stock is a hybrid corporate security. It represents an equity interest in the issuing corporation. Unlike common stock, which pays a variable dividend depending on the corporation's earnings, preferred stock pays a fixed quarterly dividend based on a stated par value. For example, an XYZ corporation might issue preferred stock with a par value of USD 50.00 and paying a quarterly 2% dividend. This would translate into a USD 1.00 dividend paid each quarter. Most corporations do not issue preferred shares. Those that do often issue multiple classes of preferred shares over time. There are three naming conventions used for distinguishing between the different preferred issues of a corporation:
With fixed dividends, preferred shares resemble fixed income instruments. Because they don't mature, they most resemble a perpetuity. Preferred shareholders generally don't have voting rights. Also, the board of directors have less of a fiduciary obligation to preferred shareholders than to common shareholders. Some Delaware court decisions have treated the board's obligation to preferred shareholders as purely contractual. Preferred stock differs from fixed income instruments in their tax treatment. Interest payments are an expense, so they are tax deductible for the corporation. Dividends are distributions of earnings, so they are not tax deductible. Also, depending on the investor's tax jurisdiction, dividends may be taxed differently from interest income. When it is first issued, preferred stock is priced by the market based on prevailing interest rates. Generally, the issuer will set the preferred's dividend yield so it issues at a price close to par. After issuance, the preferred shares trade in the stock market just like common stock. Credit rating agencies rate preferred stocks based on the issuing corporation's ability to pay dividends. Market prices of highly rated issues tend to fluctuate with interest rates. Prices of lower rated issues—just like prices of lower rated bonds—tend to fluctuate with the issuing corporation's fortunes. Preferred stock is subordinate to all the issuing corporation's fixed income obligations. If the issuer is not current on the fixed income obligations, it can pay no preferred dividends. If the issuer is liquidated, creditors must be paid in full before preferred stockholders can receive anything. However, preferred shares are superior to common shares. No dividends may be paid to holders of common stock unless dividends to preferred shareholders are also paid in full. In liquidation, preferred shareholders are entitled to at least their par value before common shareholders can receive anything.
Unlike fixed income instruments, failure of a corporation to make preferred dividend payments cannot force the firm into bankruptcy. However, while dividends are not being paid, mandatory restrictions may be placed on management, and preferred shareholders may be granted the right to vote for a number of board members. Because it is dependent on dividends not being paid, this is called contingent voting. Most preferred stock is cumulative. This means that, if a dividend is ever missed, it must eventually be made up to investors. No dividends can be paid to common stockholders until all missed dividends have been paid to preferred stockholders. If preferred shares are issued with no obligation to make up missed dividends, the shares are called non-cumulative. Callable preferred stock has an embedded option allowing the issuer to call shares, either at par or at a slight premium above par. In a typical arrangement, shares are not callable for the first few years following issuance but can be called, perhaps with a month's notice, any time thereafter. As with callable bonds, the price behavior of callable preferreds depends on whether the call option is in-the-money or out-of-the-money as well as the financial strength of the issuer. Most preferred stock is issued with a sinking fund provision that requires that the issuer set aside funds to gradually retire the issue over time. There are a number of other variations on preferred stock.
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annualized
dividend: the shares in our example would be called XYZ $4.00 preferred.
