What Are Preferred Stocks? A Beginner's Guide.

**EDITORIAL SUMMARY:** Equity in name but bond-like in behavior, preferred stock offers investors a fixed income stream in exchange for a subordinated claim, discretionary dividends, and an issuer's right to redeem. Understanding both halves of that bargain is the starting point for the asset class. Preferred stock occupies a curious position in the capital markets: it is equity in name, but it behaves, in most respects, like a bond. Investors who buy preferred shares are not betting on a company's growth in the way common shareholders are. They are betting on a company's ability to make a fixed payment, quarter after quarter, for years or decades. A share of preferred stock represents a claim on a company's earnings and assets that ranks above common stock but below all forms of debt. In exchange for giving up the higher ranking that bondholders enjoy, and the unlimited upside that common shareholders enjoy, preferred investors typically receive a dividend rate set at issuance, paid on a fixed schedule, often quarterly. The asset class has deeper roots than many investors assume. Preferred stock financed much of the American railroad expansion in the nineteenth century and became a staple of utility and bank balance sheets in the twentieth, precisely because it allowed capital-intensive companies to raise long-term funds without diluting common shareholders' control or adding to their fixed debt obligations. That heritage explains two conventions that persist today: the $25 par value, chosen to keep the securities accessible to individual investors, and the concentration of issuance among financial institutions, utilities, and real estate companies, which remain the dominant issuers. The dividend is usually expressed as a percentage of par. A 6% preferred issued at $25 par pays $1.50 annually, generally in quarterly installments of 37.5 cents, regardless of how the company's underlying business performs, so long as the company remains solvent and chooses to pay it. That last clause deserves emphasis. For most preferred structures, the dividend is discretionary. A board can suspend it without triggering a default, a flexibility that distinguishes preferred stock from debt in the most consequential way possible. Why do companies issue preferred stock at all, given that its dividends usually cost more than the interest on comparable debt? The answers vary by sector. Banks issue preferred shares because regulators count qualifying issues toward required capital, allowing an institution to strengthen its regulatory position without issuing dilutive common equity. Real estate investment trusts and business development companies, which are required to distribute most of their earnings, use preferreds to raise permanent capital without expanding their common share count. Utilities have long used them to fund infrastructure with a security whose cost sits between debt and common equity. In each case, the issuer is paying a premium for flexibility, and the investor is being compensated for providing it. Most preferred shares trade on the New York Stock Exchange under ticker conventions that append a series letter to the issuer's symbol, and they can be bought and sold through any brokerage account in the same manner as common stock. Liquidity, however, is thinner than the familiar ticker format suggests. Many issues trade only a few thousand shares a day, and quoted spreads can widen abruptly in unsettled markets, a characteristic that rewards patience and the use of limit orders. The appeal to income-oriented investors is straightforward. Preferred yields have historically run higher than yields on the same issuer's senior debt, compensating investors for standing further back in the capital structure. Many preferred dividends also receive favorable tax treatment as qualified dividend income, an advantage over the ordinary-income taxation applied to bond interest. The risks are equally straightforward, if less often advertised. Preferred dividends can be suspended, and in non-cumulative structures a skipped payment is never recovered. Preferred shares can be called away by the issuer once a call date passes, often just as prevailing rates make the security most attractive to hold. Most issues are perpetual, meaning there is no maturity date at which principal is contractually returned, and prices can remain below par for extended periods when interest rates rise. And preferred shares carry none of the legal remedies available to bondholders in the event of financial distress; in a bankruptcy, recoveries for preferred holders are frequently negligible. Understanding preferred stock, in other words, requires holding two ideas at once: it is an income instrument with bond-like cash flows, and it is a subordinated claim with equity-like risk. Subsequent entries in this Learn series examine each dimension in turn, from the yield mathematics that determine what a security actually pays, to the structural provisions that determine what happens when circumstances turn adverse.