What is Preferred Stock?

Preferred stock is like buying a full-grown tomato plant: You'll have a better chance of harvesting tomatoes. Common stock is like planting a tomato seed: While there's a greater risk of a less consistent harvest, you have more opportunity for growth.

Both categories of stock are slices of ownership in a company, however preferred shares are a less prevalent type of stock and may have characteristics of a bond. They give investors a prioritized spot in line to receive income from the company (aka dividends) before common stockholders. Preferred shares, however, usually come with little to no voting rights.

Common stock and preferred stock are the two main categories of stocks (which represent ownership or equity in a company). These two categories of stock are both purchased through brokerage firms, but they have some key differences:

1. Prevalence: Common stock is much more common (like the name suggests) than preferred stock . The bulk of preferred stock is issued by banks or even insurance companies. Many blue chip (aka well-established, generally stable) companies that offer dividends on common stock don’t issue preferred stock at all.
2. Claim on dividends: Companies that issue preferred and common stock have an obligation to pay preferred shareholders dividends on a planned schedule, before common shareholders receive any income. If a company is struggling to pay dividends, preferred shareholders will get theirs first.
3. Claim on assets: If a company files for bankruptcy or has other types of trouble, creditors (aka bond holders) will be paid first, but next in line are preferred shareholders, while common shareholders are last. If a company goes under, preferred shareholders generally have more protections than common shareholders.
4. How they act: Preferred shares, in general, act more like bonds than stock. Preferred shares tend to trade at a stable price, without substantial potential for capital gain from stock price fluctuations, because the company’s share price generally doesn’t affect their value. Instead, investors seek income from preferred stock through dividends. To top things off, preferred shares are typically rated for financial strength similarly to the way bonds are, even if they don’t offer the same degree of investment protection in terms of liquidation preference. Although it’s not common, preferred shares can also come with term limits or expiration, like bonds do, meaning the ownership contract has a set length, for example 5 years. Some preferred shares contain callable clauses that allow the issuer to recall the shares.
5. Voting rights: Common stock tends to come with voting rights, meaning shareholders can partake in important decisions like deciding who gets voted onto the board of directors, whether mergers and acquisitions take place, and other big corporate events. Preferred shares usually don’t come with voting rights.
6. Conversion: Preferred shares sometimes come with the option for shareholders to convert them into common shares. Meanwhile, common shares generally can’t be converted into preferred shares.

It’s important to read the certificate of designation to know how a preferred share operates. Investors can look at the Securities and Exchange Commission’s public documents database called EDGAR to see what information companies issuing preferred shares have shared about their preferred stock, as well as other financial disclosures related to the stock.

Companies issue preferred stock, or other securities such as common stock or bonds, as a way of raising capital to run their business or invest in new initiatives they think will drive future growth. Not many companies issue preferred stock – preferred stock tends to be most commonly issued by financial institutions, like banks and insurance companies, utility companies, and REITs (real estate investment trusts).

Companies are sometimes attracted to issuing preferred shares over other types of securities for a few different reasons:

1. Agreement length: Preferred shares might have a shorter maturity date than those of bonds, meaning, the preferred shareholder’s certificate of ownership in the preferred shares often span shorter periods of time than those of bonds.
2. Easing debt fears: If a company fails to meet a bond payment, that company could be at risk of defaulting on its issue, and as a result, face bankruptcy. By contrast, companies that issue preferred shares can defer their dividend payments, which gives them more flexibility to pay the dividends they owe when they have the cash.
3. Maintain control: Preferred stocks typically don't have voting rights. Companies can issue shares and limit the control they give to shareholders.

Yes, a single stock can issue preferred stock in different classes. This means that a company could make different groups of preferred shares available with different dividend values. In preferred stock listings (places where investors can see which shares are available to buy), preferred shares will be listed based on their dividend yield, which is a ratio that shows the value of a dividend compared to a stock’s share price. For example, if a stock has a relatively low share price and a high dividend, it might have a high dividend yield relative to other stocks. Similarly, a stock with an average dividend and a high stock price might have a low dividend yield compared to other stocks.

Many preferred stocks are rated by agencies like Standard & Poor’s Corporation and Moody’s Investors Service. The ratings are typically meant to help disclose the creditworthiness of the issuer (in this case, the company making preferred shares available), as well as the company’s ability to pay interest it owes.

On a Standard & Poor’s rating scale, shares rated BBB or higher are usually considered to be investment grade (meaning the rating agency believes the issuer's prompt payment of interest and principal (at maturity) is considered relatively safe), while preferred shares rated below BBB- are considered to be higher risk than those rated higher.

On the Moody’s scale, preferred shares rated Baa3 and above are generally seen as investment grade, while stocks rated lower than Baa3 are usually considered to be below investment grade.

Keep in mind that credit ratings do not remove market risk and are subject to change.

Preferred shares tend to land in five different categories:

1. Cumulative preferred shares: If companies defer on paying dividends on these preferred shares, the dividends will accrue, and the company will have to pay these dividends to preferred shareholders before they pay dividends to any common stockholders.
2. Non-cumulative preferred shares: These are preferred shares where, if the issuing company stalls on paying dividends, they won’t accrue, and the shareholder might never get them.
3. Trust-preferred shares: These preferred shares are offered when the company sets up a trust and issues preferred shares through that trust. The shares are funded by the debt securities of the company, and mature at the same time as the debt securities that fund them. These used to be common from banks but regulations have limited their issuance.
4. Convertible preferred stock: These preferred shares can be converted into a specific number of common shares.
5. Exchangeable preferred stock: These preferred shares can be exchanged for another type of security.