Preferred shares are shares in a company that are given priority over common shares. They provide a higher level of ownership in the company and company assets than common shares, giving them an intermediary position between bonds and common stock. If a corporation were to face bankruptcy or liquidation, distributions would be paid to preferred shareholders before they would be paid to common shareholders.
Preferred shares offer investors something of a hybrid asset class when it comes to building a properly diversified portfolio that provides a steady income stream. Although preferred shares often do not get the same media and investor attention as common shares, there are tangible benefits to including preferreds as part of a broader portfolio.
Key Features
- Ownership in a company – Like common shareholders, preferred shareholders have an ownership claim in the company. However, they are favored over common shares in that they represent higher claim on the corporation’s assets and earnings, and their dividends are given priority. Preferred shares are usually exempt from voting privileges.
- Market risk – market-listed preferred shares offer the same potential for price fluctuations as common shares, allowing for tax planning through capital gains and losses. Fixed dividends are fairly common for preferred shares though, providing a more stable payout for investors. The average dividend yield for preferred shares tends to be higher than that of common shares.
- Dividend preference – Preferred dividends are most typically paid ahead of common dividends, resulting in less uncertainty about income continuation.
- Par value – like corporate bonds, preferred shares have a par value, which makes their valuation sensitive to interest rate fluctuations.
- Redemption – preferred shares are often, although not always, redeemable by the issuer at any time, giving the shareholder more assurance over their investment. If a company decides to buy these shares back, the shareholder won't lose their investment.
- Convertibility – preferred shares often can be converted into common stock, allowing shareholders to keep one foot in and one foot out.
Hybrid Investment
Their hybrid position between stocks and bonds typically gives preferred stockholders higher yield and lower risk. Preferred shares carry many of the same features as common stocks and bonds concerning ownership claims and tax planning options through price fluctuations. Investors receive a steady stream of income (yield) and usually enjoy a higher dividend yield.
Priority
Along with a hybrid of common stock and bond features, preferred shares behave like moderated common shares, yet with greater volatility than debt. This is because preferred shares have greater priority and claim over assets in the event of default than common shares do, but a lower claim to priority compared to debt (bond) holders. In the event of deferred payments, a corporation may go into arrears, and its credit standing may be damaged if preferred dividends aren't paid. Because of this risk, there is much more incentive and pressure to pay preferred shareholders.
Flexibility & Features
Like debt offerings, preferred shares can be issued with a variety of dividend (fixed, adjustable, and floating rates), conversion (e.g. common stock, warrants) and voting features. The flexibility in their offerings make them something of an alternative investment in the stock arena and require a deeper understanding than, say, typical Class A common stock that trades on the public market, particularly when preferreds are used to construct a robust portfolio.