Preferred stock is considered a hybrid security because it has the characteristics of both a debt and an equity. Similar to fixed-income securities, preferred stock pays preferred shareholders a fixed, periodic preferred dividend. Like equity, preferred stock represents an ownership investment in that it does not require the return of the principal.
In general, preferred stock is more risky than debt but less risky than equity, so it can be a good option for some investors who are shy of incurring too much risk, yet still want to make decent returns. The preferred dividend is paid out only after interest has been first paid to regular debt holders but before common equity holders can retain any of their profits.
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Cash Income 101
Like any other debt instrument, preferred stock guarantees regular payments of a preferred dividend. Many investors invest in preferred stock when looking for a steady cash income. While interest payments on regular debt cannot be missed without risking going into default, preferred dividend on the hybrid debt of preferred stock can be suspended from time to time. However, any omitted payments must be accumulated and made up for later.
Equity Capital Basics
According to Investopedia, even though preferred stock pays out regular cash income, it does not promise the return of the investment principal like a corporate bond, as the company intends to hold the investment as equity capital. In certain cases, regular debt holdings may be converted to preferred stock as equity contributions when a company seeks relief from its obligations of paying back debt principals at upcoming due dates. Preferred stock is always listed in the equity section of a company's balance sheet.
Tax savings on interest expense makes debt financing less expensive than preferred stock financing.
Creditor-Like Rights and Liabilities
The Corporate Finance Institute reports that like creditors who provide debt financing without having control over company operations, preferred shareholders are also granted no voting rights over management issues. Preferred stock as non-voting equity does not bear the ultimate liability of a company's failure. In a liquidation and bankruptcy proceedings, both creditors and preferred shareholders get preferential treatment over holders of common stock.
Stock-Like Exchange Trading
Like common stock, preferred stock as part of the owner's equity is also exchange listed and traded. Its trading can be directly affected by corporate earnings, particularly for preferred stock that features earnings participation. In addition to receiving fixed income, this kind of preferred stock may further share company profits with common stock, a feature that pure debt securities do not have.
Other Features of Preferred Stocks
Preferred stock can resemble debt and equity on many different aspects, but it may not bear the complete resemblance. Take the example of making regular fixed payments by both preferred stock and a debt security.
For debt, interest expense is tax deductible and the company can recover part of the interest payment by a percentage point equal to its corporate tax rate. For preferred stock, dividend expense is paid using after-tax profit. So tax savings on interest expense makes debt financing less expensive than preferred stock financing.
Consider Also: Why is Preferred Stock a Hybrid Equity?, and How to Calculate Cumulative Preferred Stock Dividends