Source: Getty Images
A preferred stock is an investment that pays a consistent dividend (like a bond) but trades on an exchange (like a common stock). Preferred stocks have less-drastic price movements than common stocks, though their upside potential is severely limited. What exactly are they, and are they right for you? Below, we’ll help break it down.
What are preferred stocks?
When a company wants to raise capital, it can issue two kinds of stock: preferred and common stock. Common stock represents partial ownership of a company. When you buy it, you get certain voting rights, and you can earn immense gains if the stock’s value increases.
Preferred stocks, however, don’t represent partial ownership. Like government-issued bonds, a preferred stock is a form of fixed-income security. You buy preferred stock from a company, and, in exchange, the company pays you a consistent payout over a certain number of years.
Investors like preferred stocks because they typically have higher payouts than bonds as well as higher yields than the dividends on common stocks. Because their value isn’t tied to the market, they could hold steady during market fluctuations. The downside, however, is that a company can skip or postpone payouts on preferred stocks — a feature that distinguishes them from bonds.
Why are they called “preferred?”
Preferred stocks are called as such because preferred stockholders get preferential treatment to common shareholders.
Here’s what that means. When a company pays dividends, preferred stockholders always get paid first. Likewise, if a company goes bankrupt, they always repay preferred stockholders’ shares before common shareholders.
It’s important to note, however, that preferred stockholders aren’t always first in line. Superior to preferred stockholders are bondholders. For this reason, preferred shareholders take on some risk in buying preferred shares over bonds. In exchange for more risk, however, preferred shareholders often get a higher dividend yield.
How do preferred stocks work?
Like common stocks, you can buy or sell preferred stocks through an online broker. And, like a bond, your preferred stocks will have a “par value,” usually $25, along with a yield rate by which that par value is paid to you. For instance, if you bought a $25 preferred stock with a 1% yield rate, you’d get $0.25 each year.
Unlike common stock, the value of your preferred stock doesn’t depend on market conditions. Your common stock could have a great year, earning you immense returns, while preferred stock from the same company could remain relatively unchanged. Of course, in practice, most companies will raise the payouts on preferred stock if they’re doing exceptionally well. But the point is, they don’t have to.
If the yield on a preferred stock does change, it’s usually because of changes in interest rates. Like bonds, preferred stocks lose value when interest rates go up. Conversely, preferred stocks become more valuable when interest rates go down.
Finally, it’s important to note that the payouts on preferred stocks don’t always have a maturity date — a feature that sets it apart from bonds. That means the company doesn’t have to force you to buy back your preferred stock at the par value by a certain day. On the flip side, if the maturity date is indefinite, companies could “call up” preferred stocks at any moment, which would force you to sell back your shares.
Which companies offer preferred stocks?
Very few companies offer preferred stocks. You’ll typically find preferred stocks with banks, utilities, insurance companies, or REITs.
Are preferred stocks right for you?
Preferred stocks can be great if you want to generate income with consistent dividend payouts. They’re also ideal for near-retirees or very conservative investors who want slight upward growth at a low risk tolerance.
They’re not, however, ideal if you’re looking to build immense wealth over the long term, as your gains on preferred stocks are several limited by the payouts. You’ll get far more growth from commons stocks and ETFs, as both have unlimited upside potential.
Of course, you don’t have to be loyal to just one. Part of a successful retirement plan is to diversify your holdings, and preferred stocks can help you do just that. If you’d like to invest in preferred stocks, be sure to go beyond the yield amount and examine the company that’s issuing the yields. Though, sure, the payout yield is important, more so is the financial health of the company itself, as that can influence how long you actually get dividends.
Some offers on The Motley Fool are from our partners — it’s part of how we make money and keep this site going. But does that impact our reviews? Nope. Our commitment is to you. If a product isn’t any good, our review will reflect that, or we won’t list it at all. Also, while we aim to feature the best products available, we do not review every product on the market.