What is Preferred Stock?
From an accounting standpoint, this is a difficult asset to classify. The reason is that this isn’t common stock and it isn’t really a bond. The preferred stock is a hybrid between those two securities. It is in a class of its own and I will talk about the advantages and disadvantages of owning preferred stock. You will see after reading through this that, you can actually make comparisons between the attributes of common stock and bonds.
- Preferred Stock is a different class stock the owner doesn’t have voting rights and isn’t an owner.
- Owners of preferred stock receive dividends before common stockholders
- Traded in small increments of $25 to $100 per share.
- This is taxed as dividend income
- Bondholders still get preferential treatment to preferred shareholders.
- Like Bonds these funds fluctuate with interest rates
- These are common within certain industries
Who Issues Preferred Stock?
When companies get together and borrow funds there are many different reasons why they would choose one type of finance over another. Most companies decide to either issue bonds, so they can save money on taxes through interest payments; others would rather issue stock but this is all circumstantial. This is strategic and called the cost of capital which is a weighted model in finance showing the best mix of financing for a business.
The reason why I would advise a business to issue preferred stock is in the situation that they have a lot of outstanding common stock. When a business issues more shares of common stock, it dilutes the shares that are already owned by shareholders. There is a chance that the current investors will get angry and sell off their shares. Another important point is that common stock doesn’t have a call date. With preferred stock the business can call the shares after a certain date and stop paying the dividends.
Some warning about this is that there are companies who will issue preferred stock as a last resort. They are too risky to get financing through a bank or bondholders; likewise, their common stock is worthless already. Analyse a company well before you invest because some companies are going to be riskier than you might be able to handle.
It has an expiration date
One of the aspects that make this different than being a common stock owner is that it has an expiration date. Before you purchase shares of common stock understand that they will eventually expire and only be worth their par value. The par value is often times $27 a share, so if it is trading at $26 per share and is only going to pay you a dividend of $1.50 per year than it would be really hard for you to make this a profitable investment because this stock could be called and you would lose part of your principle.
One of my favorite advantages to buying preferred stock over bonds is that it has a tax advantage. Most preferred stock is considered qualified dividends which has a tax advantage to the investor. As an example the tax rates are from 0% to 20% range. This is a lot lower than capital gains tax or your regular income tax rates of 10% to 39.9% depending on how much money you make per year.
Interest Rate Risk
Another important thing is the interest rate risk that comes with purchasing preferred stock. Think of this like bonds in the sense that the price of preferred stock change inversely to interest rates. There is the risk that falling interest rates can cause a preferred share holder to lose principal in this type of investment.