In the investing world, you probably hear a lot about stocks and bonds, but not much about preferred stock. This is a type of stock that pays dividends to its “preferred” shareholders before common stock. However, preferred stock holders don’t have voting rights. Another drawback is that preferred stock payments are taxed at your regular tax rate instead of the capital gains rate, which is typically lower. Corporations don’t get a tax break on dividends they pay out for preferred stocks. But they are exempt from paying tax on most of income on dividends they own from other companies.
If you own preferred stock, you can expect to receive a higher yield than you would on common stock from the same company. Dividends are typically a fixed amount of the par value, or purchase price, of the stock. For example, if the par value is $10 and the fixed rate is 8%, you’d receive $.80 per share in dividend payments.
Risk of Losing Dividends
Corporations can suspend dividends for a period of time on any type of stock. They may do this if they’re having financial difficulty. Common stock dividends are usually suspended first, followed by preferred stock dividends, and finally interest payments on bonds.
With some preferred stock, the dividends have to be paid eventually, even if it’s several years down the road, unless the company liquidates. However, inflation may make the eventual dividend payment less valuable. Companies can also offer “non-cumulative” preferred stock, where unpaid dividends don’t accumulate. When a company suspends dividend payments on common stock, the corporation doesn’t have to repay it. The stockholders simply miss the dividend for that period of time.
If the company ever liquidates, preferred stockholders are paid at least the purchase value of their holdings before common stockholders, but after bondholders. However, if there’s no money left over bondholders are paid, preferred stockholders don’t receive anything and neither do common stockholders.
How to Choose Preferred Stock
Like other investment products, preferred stocks have aprospectus. There are a few things to consider when you’re purchasing a preferred stock and you’ll find most
of the answers in the prospectus. First, is the health of the company. You’re not necessarily looking for growth potential (unless you have a “participating” preferred stock discussed later), but there should be enough stability to meet dividend payments regularly. With a
failing company, there’s a risk that dividend payments will be suspended.
You can gauge a company’s health by checking its rating with a company like Standard & Poors, Moody’s, or A.M. Best Company. Preferred stock trading significantly below par may indicate that something’s wrong with the company’s health.
Another thing to consider is whether the dividend payments are cumulative or non-cumulative. In other words, if dividend payments are suspended, will they eventually be paid at some point in the future?
Companies sometimes issue several different kinds of preferred stock, each with differing levels of seniority. Preferred stock with the highest level of seniority gets cut last if the company is in financial trouble.
Another factor is the “callability” of the stock. Some preferred shares are callable and the company can call or redeem them for a certain price, usually slightly above premium, after a certain date, often without warning. Preferred stock with a higher interest rate are more likely to have a callable feature. This allows the company issuing the stock to buy back the higher-rate stock and issue new ones at a lower-rate, thereby owing less money in dividends.
While many preferred stocks don’t share in the company’s financial success, some of them are “participating” and receive additional dividends that are less than what common stockholders receive.
You may be able to convert the stock into common stock after a certain date. You may want this option if your preferred stock is non-participating.