Why Are Preferred Stocks Referred to As Preferred?

Corporations issue common and preferred stock.

A corporation can issue two types of stock: common and preferred. Common stock is partial ownership in a company and these are the shares usually referred to when discussing a company's stock. Preferred stock pays higher dividends and offers investors different opportunities for income investing. Investors should look at common and preferred stocks in very different ways.

Identification

Preferred stock shares are "preferred" because they have the preference over the common shares to receive dividends and company assets if the business is liquidated. If a company does not have enough cash to pay dividends to both the preferred shares and the common shares, the preferred shareholders must be paid first.

Function

Companies issue preferred shares as a way to raise capital instead of borrowing money by issuing bonds. Most preferred shares are issued with a fixed dividend rate that the company must pay before paying any dividend to common shareholders. The majority of preferred stock issues do not have a expiration date, so the issuing company is not required to pay back the money raised as it would if it issued bonds.

Types

Preferred shares can be issued with different features that make them more attractive to investors. Cumulative preferred shares are entitled to make up any missed dividend payments before dividends are paid on common shares. Adjustable preferred shares have their dividends changed in line with some market interest rate. This protects shareholders in a rising rate environment. Convertible preferred shares can be exchanged for common shares at a pre-determined ratio.

Considerations

Investors buy preferred shares primarily as income investment to receive the regular dividends. Although preferreds have preference over common stock to receive dividends, preferred shareholders are behind bond holders to be paid. The value of preferred shares can be affected by both the financial condition of the issuing company and the current interest rate environment. Unlike bond holders, preferred share owners usually do not have the security of a maturity date when the face value of the investment will be returned.

Potential

The dividend rate of preferred shares can be significantly better than many other investments. For example, in March 2010, the iShares S&P U.S. Preferred Stock Index ETF, symbol PFF had a dividend yield of 7.6 percent. At the same time the U.S. Treasury 10-year Note was yielding about 3.8 percent. Convertible preferred shares provided the additional potential to participate in value gains of the company's common stock.

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