Preferred Stock: What It Is & How It Differs from Common Stock

What Is Preferred Stock?

Preferred stock is a type of equity security that combines features of both stocks and bonds. It pays a fixed dividend, similar to a bond's coupon payment, while representing ownership in the company like common stock. Preferred shareholders receive their dividends before common shareholders, and they have higher priority in a liquidation, but they typically do not have voting rights or the same potential for price appreciation.

Think of preferred stock as sitting between bonds and common stocks in the capital structure. If a company runs into financial trouble, bondholders get paid first, then preferred shareholders, and finally common shareholders. This middle position gives preferred stock more safety than common stock but less safety than bonds.

Preferred stocks are most commonly issued by financial institutions (banks, insurance companies), utilities, and REITs. They appeal to income-focused investors who want a higher yield than most bonds and common stocks can provide, with more predictable income than common stock dividends. Yields on preferred stocks typically range from 5% to 7%, filling a niche between the lower yields of investment-grade bonds and the higher risk of high-yield common stocks.

How Preferred Stock Dividends Work

The primary reason investors buy preferred stock is the fixed dividend. Unlike common stock dividends, which can be raised, lowered, or eliminated at the board's discretion, preferred dividends are set at issuance and remain constant for the life of the security.

Preferred dividend characteristics:

• Fixed rate -- typically expressed as a percentage of the par value (usually $25 per share)
• Priority -- must be paid before any common stock dividends
• Predictability -- the amount does not change regardless of company performance
• Frequency -- usually paid quarterly, like common stock dividends

Example: A preferred stock with a $25 par value and a 6% dividend rate pays $1.50 per year ($25 x 6%), or $0.375 per quarter. As long as the company continues making payments, you receive exactly this amount regardless of how the company's earnings fluctuate.

If the company struggles financially and cannot afford to pay preferred dividends, what happens next depends on whether the preferred stock is cumulative or non-cumulative. This distinction is critical and one of the most important factors when evaluating different preferred stock issues.

The dividend yield on preferred stock is calculated the same way as common stock: annual dividend divided by the current market price. Because preferred stock prices fluctuate, the market yield can differ from the stated dividend rate.

Types of Preferred Stock

Not all preferred stocks are created equal. The type you choose significantly impacts your risk, return, and flexibility.

Cumulative Preferred Stock

Cumulative preferred stock is the most investor-friendly type. If the company misses a dividend payment, the unpaid dividends accumulate and must be paid in full before any common stock dividends can resume. These accumulated unpaid dividends are called dividends in arrears.

For example, if a company misses two quarters of preferred dividend payments ($0.375 each), it owes $0.75 in arrears. Before it can pay any dividend to common shareholders, it must first pay the $0.75 in arrears plus the current preferred dividend.

This feature provides meaningful protection. Most preferred stocks are cumulative.

Non-Cumulative Preferred Stock

Non-cumulative preferred stock does not accumulate missed payments. If the company skips a dividend, it is gone forever. The company has no obligation to make up missed payments. This makes non-cumulative preferred significantly riskier for investors and is generally found only in preferred stock issued by banks and financial institutions (where regulators sometimes require this structure).

Convertible Preferred Stock

Convertible preferred stock gives you the option to convert your preferred shares into a predetermined number of common shares. This provides the safety of fixed preferred dividends plus the upside potential of common stock if the company performs exceptionally well.

The conversion ratio specifies how many common shares you receive per preferred share. If the conversion ratio is 2:1, each preferred share converts into 2 common shares. Conversion makes sense when the common stock price rises enough that the converted shares are worth more than the preferred shares.

Callable Preferred Stock

Callable preferred stock gives the issuing company the right to buy back (redeem) the shares at a specified price (usually par value) after a certain date. Companies typically call preferred stock when interest rates drop, because they can issue new preferred at a lower rate and retire the expensive older shares.

This is a disadvantage for investors because your high-yielding preferred gets taken away precisely when you would most want to keep it (in a falling rate environment). The call feature caps your upside potential.

Perpetual vs. Fixed-Rate Reset

Perpetual preferred stock has no maturity date. It pays dividends indefinitely until called or converted. Most preferred stocks are perpetual.

Fixed-rate reset preferred stock pays a fixed rate for an initial period (e.g., 5 years), then resets to a new rate based on a reference rate plus a spread. This provides some protection against rising interest rates.

Preferred Stock vs. Common Stock

Understanding the differences between preferred and common stock helps you decide which belongs in your portfolio.

The fundamental trade-off is income today vs. growth tomorrow. Preferred stock provides higher, more predictable current income. Common stock provides lower current income but offers dividend growth and capital appreciation potential.

A share of Coca-Cola (KO) common stock yields about 3% but has grown its dividend every year for over 60 years. A KO preferred (if one existed) might yield 6% but would never increase. Over a long enough time horizon, the growing common stock dividend surpasses the fixed preferred dividend due to compounding.

This is why preferred stock is generally better for investors who need maximum current income (such as retirees) while common stock is better for investors with long time horizons who can wait for dividend growth to compound.

Preferred Stock vs. Bonds

Preferred stock is often compared to bonds because both pay fixed income, but there are important structural differences.

The biggest advantage of preferred stock over bonds is the tax treatment. Most preferred dividends qualify for the lower qualified dividend tax rate (0%, 15%, or 20%), while bond interest is taxed as ordinary income (up to 37%). On an after-tax basis, a 5.5% preferred dividend taxed at 15% delivers more net income than a 6% bond coupon taxed at 32%.

The biggest disadvantage is the lack of maturity. Bonds return your principal at maturity. Perpetual preferred stock never matures, so the only way to recover your investment is by selling on the open market, possibly at a loss if interest rates have risen.

How Interest Rates Affect Preferred Stock

Preferred stocks behave more like bonds than common stocks when interest rates change. Understanding this sensitivity is critical for managing preferred stock positions.

When interest rates rise:

Preferred stock prices fall. Because the dividend is fixed, the only way for the yield to adjust upward (to compete with newly issued higher-rate securities) is for the price to drop. A preferred stock paying $1.50 on a $25 par value yields 6%. If new preferreds are being issued at 7%, the old preferred must drop to approximately $21.43 ($1.50 / 0.07) to offer a competitive yield.

When interest rates fall:

Preferred stock prices rise, but gains may be capped by the call feature. If the preferred is callable at $25 and interest rates drop enough that the company wants to redeem it, your upside is limited to the call price.

This asymmetric risk (unlimited downside from rising rates but capped upside from falling rates due to callability) is one of the main criticisms of callable preferred stock.

Duration risk: Perpetual preferred stocks have very long effective durations, meaning their prices are highly sensitive to interest rate changes. A 1% rise in rates can cause a preferred stock to lose 10-15% of its value. This makes preferred stocks unsuitable for investors who may need to sell in a rising rate environment.

When to Buy Preferred Stock

Preferred stock fits specific investment goals and situations better than others.

Preferred stock is ideal for:

• Income-maximizing retirees who need high current yield and can tolerate limited growth
• Tax-conscious investors in taxable accounts who benefit from the qualified dividend rate
• Investors in stable or falling rate environments where price appreciation is possible
• Conservative investors who want higher yields than bonds with more protection than common stock
• Portfolio diversifiers adding a fixed-income-like asset that is not perfectly correlated with bonds or stocks

Preferred stock is NOT ideal for:

• Long-term growth investors who benefit more from common stock appreciation
• Rising rate environments where preferred prices are likely to decline
• Investors needing liquidity since preferred stocks trade with lower volume and wider bid-ask spreads
• Small portfolios where the limited growth potential is a significant opportunity cost

How to find preferred stocks: Preferred stocks trade on the same exchanges as common stocks but with different ticker symbols. They are often listed with a suffix like "-PRA" or "/PRA" (e.g., BAC-PRL for Bank of America Series L preferred). Many brokers have preferred stock screening tools, and ETFs like PFF (iShares Preferred and Income Securities ETF) and PGX (Invesco Preferred ETF) provide diversified access.

Building a Preferred Stock Allocation

If preferred stock fits your goals, here is how to incorporate it into your broader portfolio.

Suggested allocation by age and goals:

Preferred stock complements other income investments:

• Pair with dividend stocks for growth-oriented income
• Pair with bonds for a diversified fixed-income allocation
• Pair with REITs for real estate income
• Use in taxable accounts to take advantage of the qualified dividend tax rate
• Hold bonds (which are taxed as ordinary income) in tax-advantaged accounts instead

This approach, called asset location optimization, puts each investment in the most tax-efficient account type to maximize after-tax income.

Risks of Preferred Stock

Understand these risks before allocating to preferred stocks.

Interest rate risk. As discussed, preferred stock prices are highly sensitive to interest rate changes. In a rising rate environment, losses can be substantial and long-lasting.

Credit risk. If the issuing company faces financial distress, preferred dividends can be suspended. In bankruptcy, preferred shareholders are behind all debt holders. While preferred has priority over common stock, bondholders are paid first, and there may be nothing left.

Call risk. Callable preferred stocks can be redeemed by the issuer, typically at par value. If you bought the preferred above par, you realize a loss on the call. You also face reinvestment risk, as you must find a new investment at potentially lower rates.

Inflation risk. Because preferred dividends are fixed, inflation erodes their purchasing power over time. A preferred stock paying $1.50 per year buys less each year as prices rise. Common stock dividends that grow with inflation do not have this problem.

Liquidity risk. Many preferred stocks trade with low volume, making it difficult to buy or sell large positions without moving the price. Bid-ask spreads can be significantly wider than for the underlying common stock.

Frequently Asked Questions

Are preferred stock dividends safe?

Preferred dividends are safer than common stock dividends because they take priority, but they are not guaranteed. A company in financial trouble can suspend preferred dividends. With cumulative preferred stock, missed dividends must eventually be paid before common dividends resume. With non-cumulative preferred, missed payments are gone forever. Always check the issuing company's financial health, credit rating, and earnings stability before investing.

How are preferred stock dividends taxed?

Most preferred stock dividends are classified as qualified dividends and taxed at the favorable 0%, 15%, or 20% rate (depending on your income level). This gives preferred stocks a meaningful tax advantage over bonds, whose interest is taxed as ordinary income. However, you must meet the 61-day holding period requirement. Some preferred stock dividends, particularly from REITs and certain foreign issuers, are taxed as ordinary income. Check the tax classification before buying.

What happens to preferred stock in a company's bankruptcy?

In bankruptcy, preferred shareholders are paid after all creditors and bondholders but before common shareholders. In practice, if a company enters bankruptcy, preferred shareholders often receive partial recovery or nothing, because creditors and bondholders typically consume most or all of the remaining assets. The priority ranking provides some protection relative to common stock, but it is not a guarantee of recovery.

Can preferred stock prices go up significantly?

Significant price appreciation is uncommon for preferred stocks. Because the dividend is fixed, there is little reason for the price to rise far above par value (unless interest rates drop substantially). Callable preferred stocks have their upside further limited because the company can redeem them near par. The one exception is convertible preferred stock, which can appreciate significantly if the underlying common stock rises enough to make conversion attractive.

Should I buy preferred stock or dividend stocks?

It depends on your time horizon and income needs. Preferred stock is better for investors who need maximum current income and have shorter time horizons. Common dividend stocks are better for investors with longer time horizons who benefit from dividend growth and capital appreciation. A portfolio can include both: preferred stock for high current income and common dividend stocks for growing income over time.