There are many investment types for people to consider, with each bringing their own set of downsides and advantages. Derivatives are considered riskier than stocks, for example, which are riskier than bonds and treasury notes. Amidst this general classification, there are certain specific investment classifications that, while aren’t as common as some of their counterparts, are still worth talking about.
While everyone is well aware of equities, not as many investors know the difference between common stocks and preferred stocks. The later, while not as common, is unique in the marketplace due to their unique characteristics which makes them something of a combination between a stock and a bond. While preferred shares are technically a type of security, they share more similarities with debt based investments like bonds.
What are Preferred Stocks?
Preferred stock is a special class of equity, with each share normally getting paid a guaranteed dividend that is first in priority. In comparison, common stockholders can’t receive a dividend until the preferred stockholder’s dividend has been paid out.
That’s why these shares get their name and the main difference between preferred and common stocks, as they get first priority when it comes to many different corporate situations. In bankruptcy proceedings, for instance, preferred stockholders get their payments before common shareholders do, although not before corporate bondholders and creditors.
While these shareholders enjoy a greater deal of safety as well as premium dividend returns, they pay for this in giving up some of the potential capital gains regular common stock shareholders enjoy. If good news about a company breaks out, common shareholders will see their stock prices jump.
Preferred stock owners, whose share prices move on dividend payments and interest rate fluctuations, likely wouldn’t budge at all due to the news. On the flip side of the coin, bad news would see common stocks plunge, while preferred shares stay relatively the same.
Variability Within Preferred Stocks
Unlike common stocks, preferred shares have a wide variety of differences between them. Preferred stock owners may or may not have the right to vote depending on the situation. In some cases, preferred shares can only vote if dividends aren’t paid out. At the same time, preferred stocks are perpetually producing dividend returns in contrast to bonds, which have a defined end date.
This way, investors that are looking for ongoing dividends would find preferred stocks attractive, especially since they often have higher interest rates than bonds due to being less secure in the case of a bankruptcy.
While companies have the right to postpone dividends or in some cases skip them altogether for preferred stocks, it’s also worth mentioning that the dividends for these shares come in two forms: Cumulative and Noncumulative.
- Cumulative means that companies, should they wish to postpone a dividend, would need to pay it off at a later date. In this case, companies would need to pay off their dividend debt owed to preferred stockholders before they can issue dividends to common shares.
- Noncumulative means that companies can skip the payment completely without any repercussion, otherwise this makes it hard for the company to raise funds in the future. Some preferred shares have floating dividend rates to counteract the reduced interest risk sensitivity of these shares and to make them more competitive to the market.
Another thing to keep in mind with preferred shares is that some of them are convertible into common shares. This would give an investor the ability to lock in a certain dividend income while keeping the option to profit from large price swings in common stock.
Preferred Stock Example
Lets take a closer with an example of a preferred stock. In this example we will look at JP Morgan Preferred Series P. The ticker on TradeStation is JPM.PA but can be different for each broker so make sure to double check with them.
As you can see in the image above, JPM.PA is a noncumulative preferred share that offers quarterly dividends yielding about 5.3% and is trading around $25.50 at the time of this writing. That’s a pretty good return for owning a stable, blue-chip company like JP Morgan.
You’ll also notice a lot of similarities with common stocks. There’s only a certain amount of shares offered, in this case 34,000,000, and they are purchased the same way in the open market with a bid and ask.
The downside to owning preferred shares is even though you often get a much higher dividend payout, you usually trade that off with less growth or appreciation. Preferred shares are more affected by interest rates and relative yields than company growth.
Pros and Cons
Overall, preferred stocks have higher fixed-income potential than either bonds or common stock in the form of premium dividends which have priority over regular shares. They also require a lower investment per share in comparison to bonds while having greater liquidity then debt-based investments.
While preferred shares are less susceptible to price swings, that also works against them as they can’t profit from the potential upside when these swings work in an investors favor. While certain preferred shares are convertible, not all have this option. With most of their appeal coming from their dividend payments, preferred shares are also similar to bonds in the sense they are sensitive to changes in interest rates.
Preferred stocks are a less common choice for investors with a niche market appeal. It’s also worth noting that many companies don’t issue preferred shares altogether, with usually the larger, more established businesses having this option for their investors. Overall, they offer a middle ground between the price volatility of regular common shares and the stable, consistent interest payments from corporate bonds.
Preferred shares also vary significantly between each other in terms of convertibility, voting rights, cumulative or noncumulative dividends, etc. So investors that do want to check out preferred shares have a variety of options to chose from depending on what they’re looking for.