Preferred stock is a
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
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:
dividend: the shares in our example would be called XYZ $4.00 preferred.
dividend yield: the shares in our example would be called XYZ 8%
letter indicating the order of issuance: If the shares in our example were
the corporation's third preferred issuance, they would be called XYZ
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
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
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.
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
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.
preferred stock (ARPS) has a dividend yield that, instead of being
fixed, floats with specified
interest rates according to some formula.
preferred stock has an embedded option that allows the holder to
exchange each preferred share for a specified number of common shares.
Convertible preferred is usually callable. This allows the issuers to call
the stock and force preferred shareholders to choose between accepting
either par value or common shares. This is called a
preferred stock pays a regular fixed dividend plus an additional
dividend if the common stock dividend exceeds some specified value. Today,
this feature is rare.